Primer on Relative Valuation Methodology

Document Sample
Primer on Relative Valuation Methodology Powered By Docstoc
					  Applying Relative, Asset Oriented,
and Real Option Valuation Methods to
      Mergers and Acquisitions

             Chapter 8

                       Learning Objectives¹

• Primary learning objective: To provide students with knowledge of
  alternatives to discounted cash flow valuation methods, including
   – Market Approach – Similar to real estate valuations
        • 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
¹ See Website, Chapter 8, Alternate Valuation Ratios, Table 7, which discusses several
   alternate Equity Valuation and Enterprise Valuation Ratios.

      Applying Market-Based (Relative
            Valuation) Methods1
                                        MVT = (MVC / IC) x IT


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
1Comparable   companies may include those with profitability, risk, and growth characteristics similar to the target firm.

              Relative Valuation¹
• Value of asset is compared to values
  assessed by the market for similar or
  comparable asset.
• Requirements:
  – Identify comparable assets and market values
  – Convert market values to standardized values
    creating price multiples.
  – Compare relative values controlling for any
  ¹ Damodoran, Corporate Finance, New York University, Chapter 7   5
  Relative valuation is pervasive
• Most valuations on Wall Street are relative
  – Almost 85% of equity research reports are
    based upon a multiple and comparables.¹
  – More than 50% of all acquisition valuations
    are based upon multiples
  – Rules of thumb based on multiples are not only
    common but are often the basis for final
    valuation judgments.
  ¹ Another study indicates 10:1 in favor of relative comps.
   Relative valuation is pervasive
• While there are more discounted cash flow
  valuations in consulting and corporate finance, they
  are often relative valuations masquerading as
  discounted cash flow valuations.
   – The objective in many discounted cash flow
     valuations is to back into a number that has
     been obtained by using a multiple.
   – The terminal value in a significant number of
     discounted cash flow valuations is estimated
     using a multiple.
      Valuation Ratios versus DCF¹
• Do both
• Both entail use of value estimates, professional
  judgment, quality of information and purpose of
• Acquisition of specific, known asset or company,
  and good data, Comps may be better.
• Acquisition of general, non-specific or unknown
  asset or company, DCF may be better.
¹ See Titman, Valuation-The Art and Science of Corporate Investment Decisions, 2011, pgs. 291-2.

        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                 Price/Sales      Price/Book
                                                                 P/E2                                    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 Value of Target                   $40.72         $27.42        $81.77          $57.32     $51.81
1Trailing   or Current 52 week average. 2Projected 52 week average. 3Billions of Dollars.

 Valuation ExxonMobil Chemical
• ExxonMobil, 3rd largest following BASF & DuPont
• Division earned $3.428 Billion
• Hypothetical – assume spin off of division.
  – What is the baseline valuation? (Next slide - 10)
  – Modify baseline to adjust for relative size. (Slide 11)
  – Consider growth factors (Slide 12)

         Equity Valuation Using PE Ratios
          Chemical Company P/E Ratios
                   Share Price ÷   EPS        =    P/E Ratio
BASF                     $ 70.47         $ 5.243      13.44
Bayer                      35.64          1.511       23.59
Dow Chemical               47.40          4.401       10.77
DuPont                     41.00          2.572       15.94
Eastman Chemical           51.69           5.75         8.99
FMC                        59.52          5.729       10.39
Rohm & Hass                45.02          2.678       16.81
                                    Average           14.28

         Market Cap and PE Ratios
                     P/E Ratio   Market Cap (Billions)
BASF                  13.44            $ 38.25
Bayer                 23.59             25.63
Dow Chemical          10.77             45.25
DuPont                15.94             40.61
Eastman Chemical *     8.99              4.10
FMC *                 10.39              2.20
Rohm & Hass *         16.81             10.01
Average (Big 4)       15.94            $37.44
Average (Small 3)*    12.06              5.44

           Variation of PE Ratio
          Share Price   Current       Current/     Forecast    Forward
                         EPS        Trailing P/E     EPS       P/E Ratio
BASF          $ 70.47     $ 5.243         13.44       $ 7.27         9.69
Bayer           35.64       1.511         23.59         2.69        13.27
Dow             47.40      4.401          10.77         5.71         8.30
DuPont          41.00      2.572          15.94         3.04        13.48
Eastman         51.69        5.75          8.99         5.93         8.71
FMC             59.52      5.729          10.39         5.66        10.51
Rohm &          45.02      2.678          16.81         3.12        14.44
                         Average          14.28                     11.20

       Valuation of ExxonMobil
• Baseline valuation
  – Earnings $3.428B X P/E Ratio 14.28 = $48.94 B
• Modification to reflect relative size
  – Earnings $3.428B X P/E Ratio 15.94 = $54.63 B
• Further modification
  – Substantial dispersion (10.77 – 23.59) in P/E
    Ratios even among top 4 firms indicate risk and
    growth potential must be considered.

                    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 recently
  acquired comparable companies.
• Most accurate method whenever the transaction is
  truly comparable and recent. Boston Beer IPO
• Major limitation is that truly comparable recent
  transactions are rare.

1Also   called precedent method.

         Boston Beer Company
•   Founded 1984 6th generation brewer (HBS)
•   Drawn by European, more bitter brews.
•   Not looking to compete with Budweiser etc.
•   By 1994, largest craft brewer, grew 57%.
•   7 year round and seasonal beers.
•   Boston Lager 63% of sales.
•   European standards and raw materials.

          Boston Beer Company
• Used four contract breweries.
• Four initiatives
   – High quality – 5 masters, “date passed, beer goes”
   – Contract brewing – Pros and cons?
   – Intensive marketing & sales – 40 ¢ of each $
   – Product innovations - seasonal & private labeling
• Outlook
   – Current growth – stagnant but craft beers grew
   – Niche marketing and development?

       Boston Beer Company
• Competitors - SWOT
  – Majors – AB Bev; Coors, Miller
  – 2nd Tier – Strohs, Heileman, Genessee etc.
    • Tough for them to fight the Big 3
    • Loss of market share
    • Excess capacity – How did this help BBC?
  – Imports – German, Holland, Canada, Mexico.
    Subsequent changes due to M&A ie.
  – Craft breweries – far and away, the smallest
       Boston Beer Company
• Craft Brewing – smallest; rapid growth -40%
  – Very competitive, proprietary recipes
  – Catered to upscale market therefore expensive
  – Four types
    • Brewpubs (12%) - product consumed on site
    • Micro (22%) – limited distribution < 15,000 bbls
    • Regional (30%)- limited distribution, capital intensive,
      limited marketing, brand recognition
    • Custom (36%) – Typically contract, less capital
      intensive therefore more marketing $
          Boston Beer Company
• Recent IPOs:
   – Redhook – two plants, planning a third, allied with Bud in
     NH using distribution network. 41% growth Now Craft
     Brewers Alliance. $6.84 share price 10/5/11
   – Pete’s – Contract brewer, allied with Strohs, planned to
     build brewery. Now Pete’s Wicked Brewing. Private.
     Affiliated with Gambrinus, importers Moosehead, Corona
   – Further characteristics – See previous slides
   – Questions and Issues from the “Market”:
      • Positive reception – how well/how long? Hula hoop?
      • Age old question of sustainable growth.
      • Dependence on 2nd tier breweries?
 Boston Beer IPO Calculation
Boston Beer IPO Stock Price

Can we use Pete's or Red Hook offering information in Ex 3 as a guide?

1.   P/E Ratio = Price/EPS = Multiple

2.   Hypothetical Price

1994 ?/.29=100                                       $29

1995 ?/.35* =100               * .26 annualized      $35

3.   Apply issue discount

       1st day close   $25

       Offer Price     ($18)

                          $7            -0.39 rate

4.   Average stock price = 29+35/2= $32 X 61% = $20

           Boston Beer IPO
• November 21, 1995 , BBC issues 2.9 million
  shares at $20 each.
• Price by end of day rose 50% to $30.75.
• Today’s Price $80.49. Earlier this year,

         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.
• Primary advantage is the ease of use and
  availability of data.
• Disadvantages include presumption
  industry multiples are actually comparable
  and analysts’ projections are unbiased.
       PEG Ratio = PE Ratio/Earnings Growth
•   Used to adjust relative valuation methods for differences in growth rates among
    comparable firms.
•   Many current models assumes zero or minimal growth
•   BES/CPS example: BES/CPS 15 & 9% respectively vs industry 12.4 & 11%.
•   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

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

                                                 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 BES 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 (PE Ratio) /.11 (Growth rate of earnings) = 112.73
BES: Implied share price = 112.73 x .15 x $2.05 = $34.66         10.1% undervalued
CPX: Implied share price = 112.73 x .09 x $3.15 = $31.96         22.9% undervalued
Answer: 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.
1Solving MVT = A x VITGR x VIT using an individual firm’s PEG ratio provides the firm’s current or 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 both firms 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)
• Target’s estimated value = Target’s TBV x
  [(industry average or comparable firm market
  value) / (industry or comparable firm TBV)].
• 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
• Remember impact of GAAP = historical cost
    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/                 Beta¹            Projected 5-Year Net
                          Tangible Book Value                                 Income Growth
                                                                                 Rate¹ (%)
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 its 8/21/08
share price?
¹ Note both Beta and 5 Year Growth Rate used to cull out “irrelevant” Company.               27
                          Solution to Ingram Problem
•   Ingram’s net tangible book value per share (VIT) = ($3.4 -$.7)/.172 = $15.70¹

•   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 =

•   Based on the implied value per share, Ingram was over-valued on 8/21/08 when
    its share price was $19.30
¹ Note, we are deriving tangible book value by assuming it equals equity less intangible assets (goodwill).
The better approach would be to review or project NBV from financial statement.
   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. Used in Chapter 7/11
  Bankruptcy Cases.
• While varies with industry,
   – Receivables often sold for 80-90% of book value
   – Inventories might realize 80-90% of 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 Methods:
         Liquidation Method
• Nortel Networks – Canadian Company
  – July 1, 2011 pursuant to Bankruptcy
  – Sold 6,000 patents for $4.5 Billion at auction to
    Rockstar Bidco.
  – Consortium Apple, EMC, Microsoft, RIM & Sony
  – Google – defensive, stalking horse bid to
    discourage suits over Android & Chrome.
  – Intel – early bidder but teamed with Google

    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 current market value
• The unit’s equity value is determined by deducting
  operating liabilities from current market value Mkt. Cap
• Aggregate equity value of the business is determined by
  summing equity value of each operating unit less
  unallocated liabilities and break-up costs
• May be used by private equity/hedge and LBO deals.
             McGraw Hill Spin Off ?¹
• August 2011 – Publisher & S&P owner
• Pressure from activist hedge fund Jana Partners
  and Ontario Teachers’ Pension Plan.
• Meetings between MH (Goldman) & Jana
• MH –”mini conglomerate of non related information
  businesses”. “Education – capital intensive and
  plodding growth”?
• Lazard & JPMorgan Chase – breakup value $55
  per share versus $41 current price.
¹ See website, McGraw Hill Faces Breakup Pressures, Business Week, August 2, 2011   .   32
        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

Weighted Average Valuation Method
An analyst has estimated the value of a    Estimated    Relative   Weighted
   company using multiple valuation        Value ($M)   Weight     Avg. ($M)
   methodologies. The discounted
   cash flow value is $220 million,        220          .30        66.0
   comparable transactions’ value is
   $234 million, the P/E-based value is
   $224 million and the liquidation        234          .40        93.6
   value is $150 million. The analyst
   has greater confidence in certain
   methodologies than others.              224          .20        44.8
   Estimate the weighted average
   value of the firm using all valuation
   methodologies and the weights or        150          .10        15.0
   relative importance the analyst gives
   to each methodology.
                                                        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) - Genzyme
• 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 its NPV
  and the NPV without the real option. Art or science?
• 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.

                Analyzing Microsoft’s Real Options in
        Its Attempted Takeover of Yahoo – “handicapping”
                      Option to expand
                      contingent on
                      integration of Yahoo
                      & MSN

                                              Purchase Yahoo
                                              online search
                                              business only. Buy
Base Case:            Option to postpone      businesses later.
Microsoft offers to   contingent on
buy all outstanding   Yahoo’s rejection of    Offer same/lower
shares of Yahoo       offer                   price for all of
                                              Yahoo if board

                                              Spin-off combined
                                              Yahoo & MSN to
                      Option to abandon       shareholders
                      contingent on failure
                      to integrate Yahoo &
                                              Divest combined
                                              Yahoo & MSN. Use
                                              proceeds to pay
                                              dividend or buy
                                              back stock.          37

Shared By: