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Chapter_08_Primer_on_Relative_Valuation_Methods

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					  Applying Relative, Asset Oriented,
and Real Option Valuation Methods to
      Mergers and Acquisitions
 You earn a living by what you get,
but you build a life by what you give.
        —Winston Churchill
                                        Course Layout: M&A & Other
                                          Restructuring Activities



 Part I: M&A         Part II: M&A              Part III: M&A          Part IV: Deal        Part V:
 Environment          Process                  Valuation &            Structuring &      Alternative
                                                Modeling               Financing         Strategies

Motivations for      Business &              Public Company          Payment & Legal     Business
     M&A           Acquisition Plans            Valuation             Considerations     Alliances



 Regulatory        Search through            Private Company         Accounting & Tax   Divestitures,
Considerations     Closing Activities            Valuation            Considerations    Spin-Offs &
                                                                                        Carve-Outs

Takeover Tactics   M&A Integration              Financial               Financing       Bankruptcy &
 and Defenses                                   Modeling                Strategies       Liquidation
                                               Techniques


                                                                                        Cross-Border
                                                                                        Transactions
                  Learning Objectives

• Primary learning objective: To provide students with knowledge of
  alternatives to discounted cash flow valuation methods, including
   – Market Approach
        • 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
Secondary learning objective: Enable students to understand how real
  options apply to M&As
      Applying Market-Based (Relative
            Valuation) Methods1
                                        MVT = (MVC / IC) x IT

Where
MVT               = Market value of target company
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
                    company
1Comparable   companies may include those with profitability, risk, and growth characteristics similar to the target firm.
        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):
                                                                   Forward
            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 Mkt. Value of Target3                $40.72           $27.42           $81.77          $57.32      $51.81
1Trailing   52 week average. 2Projected 52 week average. 3Billions of Dollars.
                   Key Points: 1. Firm valuation differs significantly depending on valuation multiple used.
                                2. Valuation estimates require addition of a purchase price premium.
                        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 recent transactions of
        comparable companies.

                                          MVT = (MVRT / IRT) x IT

Where

MVT                    = Market value of target company T
MVRT                   = Market value of the recently acquired comparable company RT
IRT                    = Measure of value for recently acquired comparable company RT
IT                     = Measure of value for target company T
(MVRT/IRT)             = Market value multiple for the recently acquired comparable company RT

•       Most accurate method whenever the transaction is truly comparable and very
        recent.
•       Major limitation is that truly comparable recent transactions are rare.
•       Valuations based on this method already include a purchase price premium
1Also   called precedent method.
                  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.

                                  MVT = (MVAF / IAF) x IT

Where
MVT           = Market value of target firm
MVAF          = Market value of average firm in target firm’s or comparable industry
IAF           = Measure of value for average firm in target firm’s or comparable Industry
IT            = Measure of value for company T
(MVAF/IAF)    = Market value multiple for the average firm in target firm’s or 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.
•   Requires addition of purchase price premium
                                                                PEG Ratio
•        Used to adjust relative valuation methods for differences in growth rates among
         comparable firms.
•        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
                                                               VITGR

                                                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)1
          VITGR          = Projected growth rate in value indicator (e.g., EPS)

•        Firms whose PEG ratios > 1 considered overvalued; PEG ratios < 1 considered
         undervalued
1Valid   for VITGR > 0. For VITGR = 0 or < 0, firm value will not change or will decline.
                                                 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 BAS 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/.11 = 112.73
BES: Implied share price = 112.73 x .15 x $2.05 = $34.66
CPX: Implied share price = 112.73 x .09 x $3.15 = $31.96
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 and therefore is the more attractive takeover target.
1Solving MVT = A x VITGR x VIT using an individual firm’s PEG ratio provides the firm’s current 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 the target firm and the average firm in the industry 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)

                      MVT = (MVC / ICTBV) x ITTBV

Where
MVT            = Market value of target company
MVC            = Market value of the comparable company C
ICTBV          = Tangible book value for comparable company C
ITTBV          = Tangible book value for target company
(MVC/ICTBV)   = Market value multiple for the comparable company

• 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
    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/                 Beta             Projected 5-Year Net
                          Tangible Book Value                               Income Growth Rate
                                                                                    (%)
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 it 8/21/08
share price?
                     Solution to Ingram Problem
•   Ingram’s net tangible book value per share (VIT) = ($3.4 -$.7)/.172 = $15.70

•   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 =
    $14.92

•   Based on the implied value per share, Ingram was over-valued on 8/21/08 when
    its actual share price was $19.30
   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.
• While varies with industry,
   – Receivables often sold for 80-90% of book value
   – Inventories might realize 80-90% of book 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 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 estimated enterprise value
• The unit’s equity value is determined by deducting
  operating/non-operating liabilities from estimated
  enterprise value
• Aggregate equity value of the business is determined by
  summing equity value of each operating unit less
  unallocated liabilities held at corporate level and break-
  up costs
        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
  intangible.
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)
• 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 the NPV including the real option and the NPV
  without the real option.
• 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.

   Key Points: Total NPV = NPV Without Option + Option Value and
           Option Value = Total NPV – NPV Without Option
Microsoft Real Options Decision Tree in Attempted
               Takeover of Yahoo
                     Option to expand
                      contingent on
                        successful
                   Integration of Yahoo
                          & MSN                Purchase Yahoo online
                                                  search only. Buy
                                             Remaining businesses later.




 Base Case:         Option to postpone          Enter long-term search
Microsoft Offers      contingent on             Partnership with option
  To Buy All        Yahoo’s rejection                    to buy
Yahoo Shares              of offer

                                                Offer revised price for
                                                     all of Yahoo if
                                                circumstances change


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

• 2008 offer price for all of Yahoo = $38 per share
• Offer rejected by Jerry Yang (founder) and board of
  directors
• Microsoft withdraws offer and Yahoo share price
  drops to $16 per share
• Jerry Yang later fired
• Microsoft and Yahoo agree to online search
  partnership in 2010 in which MSN and Yahoo
  combine search businesses
              Things to Remember…
• Alternatives to discounted cash flow analysis include the following:
    – Market based methods
         • Comparable companies
         • Recent transactions
         • Same or comparable industries
    – Asset based methods
         • Tangible book value
         • Liquidation value
         • Break-up value
    – Replacement cost method
    – Weighted average method
• Firm value must be adjusted for both non-operating assets and
  liabilities.
• Real options should be considered in M&A valuation when clearly
  identifiable and when would add significantly to investment’s value