--------

Chapter 9

--------

Alternative Approaches to Valuation

2001 Prentice Hall

Takeovers, Restructuring, and Corporate Governance, 3/e

Weston - 1

Introduction
Valuation critical in M&As Framework essential to discipline valuation estimates

2001 Prentice Hall

Takeovers, Restructuring, and Corporate Governance, 3/e

Weston - 2

Comparable Companies Method

Group of companies comparable with respect to:
Size Products Recent trends and future prospects

Key ratios are calculated for each company Key ratios are averaged for group
2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 3

 Average ratios applied to absolute data for company of interest Indicated market values obtained from each ratio Valuation judgments are made

2001 Prentice Hall

Takeovers, Restructuring, and Corporate Governance, 3/e

Weston - 4

 Advantages
Common sense approach Marketplace transactions are used Widely used in legal cases, fairness evaluation, and opinions Used to value a company not publicly traded

Limitations
May be difficult to find companies that are actually comparable by key criteria Ratios may differ widely for comparable companies Different ratios may give widely different results
2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 5

Comparable Transactions Method

Valuation based on companies involved in the same kind of merger transactions Market value refers to transactions in a completed deal More directly applicable than company comparisons May be difficult to find truly similar transactions within a relevant time frame
2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 6

Spreadsheet Approach to Valuation and Mergers

Procedure
Historical data for each element of balance sheet, income statement, and cash flow statement are presented 7 to 10 years Detailed financial analysis is performed to discover financial patterns

2001 Prentice Hall

Takeovers, Restructuring, and Corporate Governance, 3/e

Weston - 7

 Additional analysis
Business economics of industry in which company operates Company's competitive position Assessments of financial patterns, strategies, and actions of competitors

Based on analysis, relevant cash flows are projected Procedures similar to capital budgeting analysis
2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 8

 Capital budgeting decisions

Process of planning expenditures whose returns extend over a period of time An acquisition is fundamentally a capital budgeting problem: Mergers do not make sense if buyer pays too much resulting in negative NPVs

2001 Prentice Hall

Takeovers, Restructuring, and Corporate Governance, 3/e

Weston - 9

 Spreadsheet projections
Provide great flexibility in projections Important to understand underlying growth patterns NPV of acquisition obtained from sum of free cash flows discounted at applicable cost of capital FCF NPV ! where : (1  k )
n t t t !1

FCFt = free cash flows in period t = X t ( 1  T)  I t X t ! before - tax cash flows in period t T = tax rate I t ! investment outlays in period t k = cost of capital
2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 10

 Advantages of spreadsheet approach

Expressed in financial statements Any desired detail of individual balance sheet or income statement accounts Flexibility and judgment in formulating projections

2001 Prentice Hall

Takeovers, Restructuring, and Corporate Governance, 3/e

Weston - 11

 Disadvantages of spreadsheet approach

Numbers used in projections may create illusion that they are actual or correct numbers May lack link between projected numbers and business logic May become highly complex Details may obscure important driving factors

2001 Prentice Hall

Takeovers, Restructuring, and Corporate Governance, 3/e

Weston - 12

Formula Approach
No real distinction between spreadsheet approach and formula approach
Both use discounted cash flow analysis Spreadsheet approach expressed in form of financial statements over period of time Formula approach summarizes same data in compact form Formula approach helps focus on underlying drivers of valuation
2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 13

 Development of compact valuation formulas

Valuation necessarily requires forecasts Usually assumes systematic relations between time periods, variables

Key variables and relationships

Revenues (Rt)
Basic driver of a firm's value Market value to revenue multiples usually calculated for comparing values of firm in same industry Main approach to valuing Internet stocks
2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 14

 Growth rate (g)

Defined as rate of change in revenues Growth rate will mirror various combinations of cash flow patterns that reflect ebb and flow of strategic and competitive factors

Net operating income margin (m) after deducting operating costs from revenues including:
Cost of goods sold Selling, general, and administrative expenses Depreciation expenses

Actual tax rate (T)

2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 15

 Investment (It)
Investment as a ratio of revenues Defined as the change in total capital over the previous period Change in total capital
Investment in working capital, gross or net Investment in fixed assets, gross or net

Number of periods of supernormal growth (n)

Defined by firm's competitive advantage Supernormal growth period will end when competition erodes the firm's competitive advantage
2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 16

 Marginal weighted cost of capital (k)

Cost of equity After-tax cost of debt Weighted average of the two based on target financing proportions

Value drivers for net operating income margin (m) and investment (I) are expressed as a percentage of sales could be obtained through a linear regression relationship with revenues

2001 Prentice Hall

Takeovers, Restructuring, and Corporate Governance, 3/e

Weston - 17

 Sensitivity analysis
Purpose
Check impact of a range of alternative possibilities Provide framework for planning and control

Sensitivity analysis of model variables:

Decrease in revenues growth rate (g) lowers valuation Increase in investment requirement percentage (I) lowers valuation Operating profit margin (m) is a powerful value driver when m is increased, valuation increases

2001 Prentice Hall

Takeovers, Restructuring, and Corporate Governance, 3/e

Weston - 18

 Valuation is very sensitive to the cost of capital (k) used in analysis when cost of capital is increased, valuation falls Sensitivity to n and T predictable in direction and magnitude
When period of supernormal growth is reduced, valuation is reduced When tax rate is reduced, valuation is increased

In many practical cases, second term in valuation model represents a higher proportion of valuation than first term must be careful as to assumptions about factors affecting exit or terminal value
2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 19

 Limitations of the formula approach

Less flexibility in reflecting forecasts for individual years Calculations use financial statement data not directly shown in the formulas

2001 Prentice Hall

Takeovers, Restructuring, and Corporate Governance, 3/e

Weston - 20

Cost of Capital Measurement

Steps involved in calculation of cost of capital
Calculate cost of equity capital Calculate cost of debt Formulate applicable financial structure or financial proportions Apply applicable financial proportions to cost of equity and cost of debt Final result is weighted cost of capital
2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 21

 Cost of equity
Capital Asset Pricing Model (CAPM)
ks = Rf + [RM - Rf] Fj Risk-free rate (Rf)
Related to returns on U.S. government bonds Rates on relatively long-term bonds should be used since discount factor is used in valuation involving long periods

Market price of risk (RM - Rf)

For many years, estimated to be in range of 6.5 to 7.5% For new economic paradigm since mid 1990s, estimated to be in the range 4% to 5%

Beta (Fj )
Measures how returns on the firm's common stock vary with returns on the market as a whole High beta stocks exhibit higher volatility than low beta stocks in response to changes in market returns
2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 22

 Dividend growth model

Cost of equity based on the constant-growth dividend valuation model D1 So ! ks  g D1 g ks ! So

Required return on equity is expected dividend yield (D1/S0) plus expected growth rate of dividends in perpetuity (g)

2001 Prentice Hall

Takeovers, Restructuring, and Corporate Governance, 3/e

Weston - 23

 Bond yield plus equity risk premium

Cost of equity = Average yield to maturity of bonds for the industry with same rating as the firm's debt + historical average firm's equity risk premium over its bond yield For the industry, analyze historical yield on equity as compared with average yield to maturity on bonds for the industry

2001 Prentice Hall

Takeovers, Restructuring, and Corporate Governance, 3/e

Weston - 24

 Estimating the cost of equity capital

Use information generated by financial markets Estimate cost of equity using multiple methods Consider general equity market uncertainty Consider estimates for other companies in same industry Use judgment to arrive at an estimate

2001 Prentice Hall

Takeovers, Restructuring, and Corporate Governance, 3/e

Weston - 25

 Cost of debt
Cost of debt calculated on an after-tax basis because interest payments are tax deductible After-tax cost of debt = kb(1 - T ) Before-tax cost of debt, kb
Can be obtained from a weighted average of the yields to maturity of all the firm's outstanding publicly held bonds Can be obtained from published promised yields to maturity based on bond rating category

2001 Prentice Hall

Takeovers, Restructuring, and Corporate Governance, 3/e

Weston - 26

 Weighted cost of capital

Cost of capital, k, is weighted average of marginal cost of equity and debt k = kb(1-T)(B/V)+ks(S/V) where:
kb ks T B S V = = = = = = cost of debt cost of equity tax rate value of debt value of equity total value of firm = B + S

or k = ku(1-TL)
where:
ku = cost of capital of an unlevered firm L = B/V
2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 27

 Methodology focuses on current market opportunity costs, not book or historical costs May use book or market values to provide guidelines Use judgment to estimate target financial proportions

2001 Prentice Hall

Takeovers, Restructuring, and Corporate Governance, 3/e

Weston - 28

 Merger premiums
It is wrong to conclude that number of shares paid in a stock-for-stock deal is unimportant just because it is a paper-for-paper deal Premium paid decides the percentage of combined ownership each party to the merger will control

2001 Prentice Hall

Takeovers, Restructuring, and Corporate Governance, 3/e

Weston - 29

 Higher premium paid:

Greater the percentage ownership of the new firm by the shareholders of the acquired firm Greater the value per share dilution for acquirer shareholders Greater the EPS dilution for acquirer shareholders

Presence of merger economies from synergies, cost savings, etc. can recover acquirer premiums paid, could even make mergers accretive
2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 30

Summary
All valuation methods have strengths and weaknesses Employ multiple methods of valuation in takeover analysis Valuation should be guided by a business economics outlook for the firms Ultimately judgments are required for valuations
2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 31