Video Games and Valuations
February 15, 2008, 2:07 pm
Link to This
o Mergers & Acquisitions
Earlier this week, we covered Yahoo’s brief, polite rejection of
Microsoft’s bear-hug letter. In making the determination that
Microsoft’s bid “substantially undervalues” its assets, Yahoo had the
benefit of advice from three investment banks.
They likely provided Yahoo with a valuation of the company, one that
presumably asserted that Yahoo was worth a lot more. But how reliable
is such valuation information? The understanding and pricing of assets
is a relatively young discipline that has made revolutionary strides in the
past four decades. However, there are still substantial problems with
valuation practices that make them a useful tool, but one that should be
viewed with a wary eye.
First, there are a number of different valuation methods. Two common
and accepted techniques in the context of mergers and acquisitions are
discounted cash-flow analysis and a comparable-companies analysis.
A discounted cash-flow analysis calculates the present value of the
future free cash flows of a corporation by discounting the cash flows at a
specific discount rate.
A comparable-company analysis typically compares the corporation
being valued against selected, similarly situated, publicly-traded
companies. These companies are compared using price multiples of
each corporation’s stock against selected benchmarks, such as price to
future earnings, price to forecasted sales, or price to book value.
Both are prone to subjectivity.
For example, a discounted cash-flow analysis is conducted by
discounting back at a chosen discount rate the projected future free cash
flows and terminal value of an asset. In performing this analysis, there
are three central choices to make, each of which can significantly affect
the final valuation. These are the correct forecasted free cash flows to
utilize, the appropriate discount rate and the terminal value of the asset.
There is substantial leeway to determine each of these, and any change
can markedly affect the discounted cash-flow value.
Keep in mind that an increase of one percentage point in the discount
rate on a stream of cash flows in the billions of dollars can decrease the
discounted cash-flow value by tens if not hundreds of millions of dollars.
In the case of a comparable-company analysis, the subjectivity arises in
choosing the comparable companies.
The highly subjective nature of valuations rears its head most acutely
with fairness opinions. A fairness opinion is an opinion typically
provided by an investment bank to an acquisition target that the price
being paid by an acquirer is fair from a financial perspective. The
opinion is often prepared using the valuation techniques above.
But investment banks are usually under pressure from their clients to
come to the “right” answer on fairness. Moreover, investment banks are
often conflicted in providing theses opinions, because their
compensation is often contingent upon completion of a transaction (and,
by extension, their finding of fairness) or they may want to preserve a
future stream of business. The subjectivity of valuation and the
conflicted nature of banks makes the process vulnerable to
manipulation to arrive at fairness.
To illustrate these issues, let’s look at the recent disclosure made by
Activision, the video game maker, concerning the fairness opinion
provided to it by Allen & Company.
Activision is acquiring Vivendi Games based upon a valuation of
Vivendi Games at $8.12 billion and a per-share price for Activision
common stock of $27.50. Simultaneously with this acquisition, Vivendi
is purchasing from Activision 62.9 million newly issued shares of
Activision common stock, at $27.50 per share. After the closing of the
transaction, the new Activision will commence a cash tender offer for up
to about 50 percent of its shares not owned by Vivendi.
If the tender offer is fully subscribed, Vivendi and its subsidiaries are
expected to end up owning about 68 percent of Activision.
This is a complicated transaction, made more so by the fact that
Activision will remain a public company and Vivendi Games is a private
company, making its valuation difficult. Nonetheless, Allen & Company
has opined that these transactions are fair, from a financial point of view,
to Activision and its shareholders.
Activision shareholders are required to approve this transaction, and the
analyses underlying Allen & Company’s fairness opinion are disclosed in
the proxy statement for this vote.
First, let’s look at the disclosure concerning the discounted cash flow
performed by Allen & Company on Activision.
Discounted Cash Flow Analysis. Allen & Company’s DCF approach
was based upon certain financial projections and estimates for
Activision derived from Wall Street analyst reports. Allen & Company
used a DCF analysis to identify a range of present values for Activision’s
common stock based upon terminal forward P/E multiples ranging from
21x - 25x and discount rates ranging from 12% - 13%. Allen & Company
determined that the per share transaction price [$27.50] exceeded the
range of values indicated by its DCF analysis.
There are a couple of interesting things here. First, Allen & Company did
not use Activision’s internal projections but rather Wall Street estimates.
This occurs sometimes; if Allen had used Activision’s own projections,
they would have been required to be disclosed. Activision may not have
wanted this to happen. In addition, sometimes useful internal
projections simply don’t exist. In such circumstances, the bank will take
guidance from their client as to which estimates are the “best.” But Allen
& Company has not disclosed the estimates utilized, so we cannot
ascertain whether they are appropriate.
Moreover, in presenting its discounted cash flow, Allen & Company has
not disclosed how it derived its discount rate, the number of years of
projections used or what its calculated per-share price ranges were. In
short, the description of the discounted cash flow is not particularly
helpful if you wanted to make your own assessment of Allen &
A bigger potential problem with this disclosure is revealed when we look
at Allen & Company’s discounted cash flow disclosure for Blizzard
Entertainment, which makes the popular Web-based tame “World of
Warcraft” and is the main component of Vivendi Games:
Discounted Cash Flow Analysis. Allen & Company estimated the
after-tax unlevered free cash flow for Blizzard Entertainment beginning
with the second quarter of 2008 through year-end 2012. Projections for
2008 and 2009 were obtained from Vivendi Games management, and
Allen & Company extrapolated from these projections Blizzard’s results
for 2010 through 2012. Allen & Company discounted the free cash flows
back to a present value as of December 1, 2007 using discount rates
ranging from 10.5% to 12.5%. In addition, Allen & Company assumed
perpetuity growth rates ranging from 4.0% to 6.0% in order to calculate
a terminal value. Using the midpoint for the range of discount rates of
11.5% and a range of perpetuity growth rate assumptions from 4.5% to
5.5%, the DCF analysis indicated an enterprise value for Blizzard
Entertainment ranging from $7.7 billion to $8.8 billion.
This disclosure here is more fulsome. Unlike in the case of Activision
itself, the proxy details more specifically how Allen & Company
calculated its terminal value, the number of years of projections used
and actually provides a range of values. Not surprisingly, the values are
quite close to the actual price being paid by Activision to acquire Vivendi
Games, since Blizzard is the primary component of this division.
But there are some odd things here. First, the discount rate here (11.5%)
is lower than the range used for Activision (12%-13%). The lower the
discount rate, the higher the value of the company. Since these two
companies are in the same business, you would expect them to be
assigned the same discount rates — or at least see a calculation using the
The odder thing is the perpetuity growth rate assumption. This
assumption is used to calculate the terminal value of the asset. It
projects the cash flows out for the terminal value using an estimated
future stable growth rate for the company.
This “perpetuity growth rate” figure cannot exceed the growth rate of the
national economy, generally a real figure of 3 percent to 4 percent.
Otherwise, the company would eventually become bigger than the whole
economy — a clear impossibility. And the higher the rate, the more the
company will be worth. Based on the numbers above, I estimate that a 3
percent perpetuity growth rate would reduce the discounted cash-flow
value by about $1.35 billion.
There may be an explanation for this — use of a nominal rather than a
real number perhaps — but without the comparable numbers for
Activision, it is hard to make a determination.
And again, one has to wonder about why Allen & Company used a
different method to calculate terminal value for Activision — a multiple
method rather than a perpetuity growth rate. Why?
The lack of full disclosure and the use of different numbers and methods
raises more questions than answers. We asked Allen & Company to
comment on the fairness opinion Friday, but they declined.
The Activision opinion gets at a broader problem with fairness opinions
and valuation generally. There are no guidelines or standards for
valuation, and the banks often do not disclose enough information in
proxy statements to make any meaningful comparison or assessment. In
other words, the problems above with Allen & Company’s disclosure are
quite common with proxy-statement disclosure of fairness opinions and
valuation. Occasionally, the Securities and Exchange Commission will
crack down on this and require greater disclosure, but they haven’t been
successful in the longer term.
Because of all this, many believe that fairness opinions are not worth the
paper they are printed on. Marc Wolinsky, a partner at Wachtell,
Lipton, Rosen & Katz, seemed to suggest as much when he quipped
in October: “A fairness opinion — you know, the Lucy sitting in the box:
‘Fairness Opinions, 5 cents.’”
At this point, I’d have to agree.
Fairness opinions are effectively required in M&A transactions by the
Delaware courts, but the courts would do well to end this requirement
so that fairness opinions can be assessed and obtained on their merits.
Then this whole game of half-disclosure can stop. In the meantime, rely
upon them at your risk.
8 comments so far...
hopefully yahoo has fired its so called advisors.$31 is on the low side i would like to
see $40 as a shareholder .then again no else is offerering anything!…yahoo is quickly
running out of time to come up with a better offer for sharholders ( yahoos owners)
jerry yang needs to put something on the table or he will be out of his own
— Posted by plang
My finance professor would have a heart attack if we ever used a 6% growth rate.
— Posted by AFM
I think both Allen and Company and The Deal Professor are missing a couple of
1. Appears that Allen and Co use relative a valuation method (multiples) to estimate
terminal value and then plug that into the DCF model which is more a measure of
intrinsic value. So if the market valuation currently is way off, then the DCF model is
pretty flawed too.
2. Just because both firms are in the same industry why does the Deal Prof think they
should have the same discount rates? The risk profiles of the two firms are different
and therefore their cashflows should be discounted at different rates.
3. In terms of the perpetual growth rate - why does the Deal Prof think that they
must be using the real rate when everywhere else Allen & co is using the nominal
rate? A nominal long-term risk free rate can be used for this figure and 4% looks OK
if one looks at 10 and 30 yr US treasury yields.
4. From the disclosures it is not clear if Allen & Co is using the cost of capital to
discount cash flows to equity in valuing Activision’s share price.
— Posted by Student
Your estimate of the appropriate terminal growth rate mixes real GDP growth with
nominal GDP growth. You are correct in asserting that real GDP growth tends to be
2.5-3.5% in the U.S. (4-5% globally), but nominal GDP growth in the U.S. tends to be
6%+ and globally higher. As companies are paid in and report nominal dollar
revenues, the appropriate terminal discount rate for the market would be the
nominal GDP growth of the market (or 6+% for a company whose revenues are 100%
derived from the U.S. market). . .
— Posted by JG
My last finance teacher, just 3 weeks ago, harped on and on about this..
And just as I asked him I will ask again- are there any real alternatives to fairness
— Posted by Leroy
isnt’t the discount rate tied to company capital structure anyway, so depending on
D/E ratios you would use different waccs even for companies with same profile?
— Posted by panda
1) Valuation is an art, not a science. Even the most careful and intelligent of persons
can come up with substantially different values for the same asset or business using
the same data. There is no single “right” answer.
2) In the context of an M&A transaction, valuation is a critical negotiation tool.
Bankers use valuation to persuade their client’s opposite to accept their transaction
demands. They will therefore act as responsible advocates and emphasize all those
factors which support their client’s view on valuation and de-emphasize those factors
which do not. In M&A, valuation is an argument, not a search for “the truth.”
3) Finally, the only reason anyone sees the results of these arguments is due to proxy
disclosure rules and the Delaware requirement cited which requires fairness
opinions. As I have stated elsewhere, fairness opinions are a waste of time and
money, even–or perhaps especially–from a legal point of view. Delaware should
abolish the requirement, period.
— Posted by The Epicurean Dealmaker
JG’s point about real and nominal numbers is correct. My point in the post is that the
proxy does not disclose what Allen & Co. are using. Moreover, the lack of any true
standards and guidelines for valuation make it hard for any outsider to assess.
I agree with the always smart Epicurean Dealmaker’s point about fairness opinions.
Forcing the whole thing into the fairness opinion mold misses the point and the
Delaware court’s would do well to end the per se legal requirement for them. There
would still be a natural tendency to obtain these opinions for liability shielding
purposes but it might otherwise force boards to more strongly evaluate the need for
these opinions and what they really do and do not opine to.
— Posted by Steven M. Davidoff
Add your comments...