Valuation - the Strategic Perspective

Part III.  Valuation — The Strategic Perspective

Chapter 9

Alternative Approaches to Valuation

1. Introduction

1. Valuation critical in M&As

1. Acquisition failures can result from bidder paying too much
2. Value of bidder tender offer may stimulate competing bidders
3. In bidder contest, winner is firm with highest estimates of value of target

1. Framework essential to discipline valuation estimates
2. Valuation methods

1. Comparable companies or comparable transactions
2. Discounted cash flow (DCF) spreadsheet approach
3. Formula approach

1. Comparables Approaches (See models disk)

1. Comparable companies analysis

1. Group of companies comparable with respect to:

1. Size
2. Similarity of products or production methods
3. Age of company
4. Recent trends and future prospects

1. Key ratios are calculated for each company.  For example:

1. Market value of shareholders' equity to sales
2. Market value of equity in relation to book value of equity (market/book)
3. Market value of equity to earnings (price-to-earnings ratio)
4. Sales or revenue per employee
5. Net income per employee
6. Assets needed to produce $1 of sales or revenue

1. Key ratios are averaged for group
2. Average ratios are applied to absolute data for company of interest to obtain its values.  For example:

Equity value of Company W = Average market-to-sales ratio of comparables

        × Company W’s Sales

1. Valuation judgments are made
2. Advantages

1. Common sense approach: similar companies should sell for similar prices
2. Marketplace transactions are used
3. Widely used in legal cases
4. Used by investment bankers in fairness evaluation and opinions
5. Can be used to establish valuation relationship for a company not publicly traded

1. Limitations

1. May be difficult to find companies that are actually comparable by key criteria
2. Ratios may differ widely for comparable companies
3. Different ratios may give widely different valuations
4. Companies in similar businesses and comparable in size may differ in track records and opportunities

1. Growth rates in revenues
2. Growth rates in cash flows
3. Riskiness (beta) of companies
4. Stages in life cycle of industry and company
5. Competitive pressures
6. Opportunities for expansion

1. Comparable transactions analysis

1. Valuation based on companies involved in the same kind of merger transactions
2. Key ratios are calculated for each comparable deal based on actual transaction prices.  For example:

1. Total paid to target’s sales
2. Total paid to target’s book value
3. Total paid to target’s net income
4. Premium to target’s pre-merger market value
5. Premium to combined firm pre-merger market value

1. Key ratios are averaged for group and applied to merger transaction of interest to obtain its value.  For example:

        Value Paid to Target W = Average total paid-to-target’s sales ratio

                × Target W’s sales

        Value Paid to Target W = Market value of Target W 

                × (1 + Average premium to targets)

        Value Paid to Target W = Market value of combined company

                × (1 + average premium to combined firms)

                –  Market value of buyer

1. More directly applicable than company comparisons

1. Companies may combine diverse activities
2. M&A transactions involve premiums so results from comparable companies need to be adjusted upward

1. Limitations

1. May be difficult to find transactions within a relevant time frame
2. Transactions may not be truly similar
3. Resulting ratios may vary widely
4. Considerable judgment may be required
5. Does not take into account the estimated synergies that may vary between different transactions

1. The DCF Spreadsheet Methodology

1. Procedure

1. Historical data for each element of balance sheet, income statement, and cash flow statement are presented — 5 to 10 years
2. Detailed financial ratio analysis is performed to discover financial patterns
3. Additional critical analysis

1. Business economics of industry in which company operates
2. Company's competitive position
3. Assessments of financial patterns, strategies, and actions of competitors

1. Based on analysis, relevant cash flows are projected
2. Procedures similar to capital budgeting analysis

1. Capital budgeting decisions

1. Definition

1. Process of planning expenditures whose returns extend over a period of time
2. Generally in relation to investment in fixed assets, but concept applicable to investment in cash, receivables, inventory, as well as M&A activities

1. Importance of capital budgeting decisions:

1. Consequences of decisions continue for number of years
2. Require effective planning to assure proper timing
3. Size of outlay may require financing to be arranged in advance
4. Size of outlay means decisions and their timing can make or break the firm

1. Net present value (NPV)

1. Definition — Present value of all future cash flows discounted at the cost of capital minus the cost of investments made over time compounded at the opportunity cost of funds

[pic 1] 

1. Standard method for evaluation and ranking of investments

1. NPV method correctly assumes reinvestment at cost of capital
2. Value additivity principle

1. Sum of project NPVs is the same regardless of how they are combined
2. Can consider projects independently
3. Firm value is sum of component project NPVs

1. NPV is amount project adds to firm value — maximizing NPV maximizes firm value

1. An acquisition is fundamentally a capital budgeting problem: Mergers do not make sense if buyer pays too much resulting in negative NPVs

1. Real options analysis

1. NPV approach does not recognize flexibility in investment decisions

1. Postponement
2. Abandonment
3. Modification

1. Negative NPV investment may be positive if value of flexibility is included
2. Example:
   Postpone investment until Year 2
   Investment in Year 2 = $50 million
   Present value of incremental cash flows = $40 million
   Cost of capital = 10%
   
   NPV analysis:
           [pic 2]
   
   Real Options analysis:
   Postponement option can be view as a call option in the Black-Scholes (1973) option pricing model:
           [pic 3]
   
   where  
           [pic 4]
   N(d1) represents a probability term measuring the change in C in response to a change in S.  N(d2) is the probability that the option will be exercised
   
   Key variables are:
   [pic 5]
   
   Value of investment outcome (value of call option) = +$1.3 million
3. NPV approach can obtain similar results by doing a sensitivity analysis

1. Spreadsheet projections (See models disk for applications)

1. Provides great flexibility in projections — growth rate for each item in spreadsheet could be different from one another and from year to year
2. Important to understand underlying growth patterns

1. Growth rate consistent with forecast for economy
2. Growth rate consistent with industry
3. Growth rate consistent with market share in relation to competitors

1. NPV of acquisition obtained from sum of free cash flows discounted at applicable cost of capital

[pic 6]

1. Free cash flows

        Net Revenues

                – Operating Expenses        

        Net Operating Income (NOI)

                – Income Taxes        

        Net Operating Profits after Taxes (NOPAT or NOI(1-T))

                + Depreciation        

        Gross Cash Flows[pic 7]

                – Change in working capital
                – Capital expenditures        Investments
                – Change in other assets net                
        Free Cash Flows