1. Prof. Ian Giddy New York University Mergers & Acquisitions Valuation Tools

2. Copyright ©1999 Ian H. Giddy M&A 2 Mergers and Acquisitions l Mergers & Acquisitions l Divestitures l Valuation l Implementation Concept: Is a division or firm worth more within the company, or outside it?

3. Copyright ©1999 Ian H. Giddy M&A 3 What's It Worth? Valuation Methods l Book value approach l Market value approach l Ratios (like P/E ratio) l Break-up value l Cash flow value

4. Copyright ©1999 Ian H. Giddy M&A 4 What's It Worth? Valuation Methods l Book value approach l Market value approach l Ratios (like P/E ratio) l Break-up value l Cash flow value -- present value of future cash flows

5. Copyright ©1999 Ian H. Giddy M&A 5 How Much Should We Pay? Applying the discounted cash flow approach, we need to know: 1.The incremental cash flows to be generated from the acquisition, adjusted for debt servicing and taxes 2.The rate at which to discount the cash flows (required rate of return) 3.The deadweight costs of making the acquisition (investment banks' fees, etc)

6. Copyright ©1999 Ian H. Giddy M&A 6 How Should We Pay? l Payment in cash  (What happens to acquirer's stock price?) l Payment with debt  (When you buy something by mail order, it's best to pay with a credit card) l Payment with equity shares  (Figure out how many shares acquirer needs to offer)

7. Copyright ©1999 Ian H. Giddy M&A 7 The Cost of Capital Required rate of return on equity, R E, may be computed from the Capital Asset Pricing Model (CAPM): R E = R F + Beta (R M - R F ) where R F = risk-free rate Beta= nondiversifiable risk factor, and R M = return on the market. In short, the discount factor should reflect the riskiness of the acquisition.

8. Copyright ©1999 Ian H. Giddy M&A 8 Application l Fakawi Navigation plans to acquire Feng-Shui Compass Co. This would result in $25 million of incremental operating revenues in each of the first 5 years, and in $15 million of additional debt servicing costs per annum, as well as $5 million in tax shields. Fakawi expects to divest the target in year 6 for $100 million. The Treasury note rate is 6%, and the S&P return is 16%. Fakawi's advisors estimate that Feng- Shui has a beta of 1.3. For this advice they are charging 2% of the acquisition price. l What is the maximum price that Fakawi should offer for Feng-Shui?

9. Copyright ©1999 Ian H. Giddy M&A 9 A New Application l Mekkawi Construction of Lebanon plans to acquire Nassir Cement Co. This would result in $25 million of incremental operating revenues in each of the first 5 years, and in $15 million of additional debt servicing costs per annum, as well as $5 million in tax shields. Mekkawi estimates Nassir will be worth $100 million in year 6. The US Treasury bond rate is 6%, and the country risk premium in Lebanon is estimated to be 4%. The long run expected return on a portfolio of equity investments available to Lebanese investors is 13%. Mekkawi's advisors, Deloitte and Touche, estimate that Nassir has a beta of 1.3. For this advice they are charging 2% of the acquisition price. l What is Nassir Cement worth to Mekkawi Construction?

10. Copyright ©1999 Ian H. Giddy M&A 10 What’s a Company Worth? l Required returns l Types of Models  Balance sheet models  Dividend discount models  Corporate cash flow models  Price/Earnings ratios l Estimating Growth Rates l Application IBM

11. Copyright ©1999 Ian H. Giddy M&A 11 http://barcharts.com

12. Copyright ©1999 Ian H. Giddy M&A 12 The Cost of Equity Depends on the Company’s Risk Premium r j = R F +  j (r m - R F ) where: r j = Required return on asset j; R F = Risk-free rate of return  j = Beta Coefficient for asset j; r m = Market return The term [  j (r m - R F )] is called the risk premium and (r m -R F ) is called the market risk premium

13. Copyright ©1999 Ian H. Giddy M&A 13 Beta Estimation in Practice: Bloomberg

14. Copyright ©1999 Ian H. Giddy M&A 14 Estimating Disney’s Cost of Equity l Disney’s Beta = 1.40 l Riskfree Rate = 5.00% (Long term Government Bond rate) l Risk Premium = 5.50% (Approximate historical premium) l Expected Return = 5.00% + 1.40 (5.50%) = 12.70%

15. Copyright ©1999 Ian H. Giddy M&A 15 Equity Betas and Leverage l The beta of equity alone can be written as a function of the unlevered beta and the debt-equity ratio  L =  u (1+ ((1-t)D/E) where  L = Levered or Equity Beta  u = Unlevered Beta t = Corporate marginal tax rate D = Market Value of Debt E = Market Value of Equity

16. Copyright ©1999 Ian H. Giddy M&A 16 From Cost of Equity to Cost of Capital l The cost of capital is a composite cost to the firm of raising financing to fund its projects. l It is the discount rate that will be applied to capital budgeting projects within the firm

17. Copyright ©1999 Ian H. Giddy M&A 17 The Cost of Capital ChoiceCost 1. EquityCost of equity - Retained earnings- depends upon riskiness of the stock - New stock issues- will be affected by level of interest rates - Warrants Cost of equity = riskless rate + beta * risk premium 2. DebtCost of debt - Bank borrowing- depends upon default risk of the firm - Bond issues- will be affected by level of interest rates - provides a tax advantage because interest is tax-deductible Cost of debt = Borrowing rate (1 - tax rate) Debt + equity = Cost of capital = Weighted average of cost of equity and Capitalcost of debt; weights based upon market value. Cost of capital = k d [D/(D+E)] + k e [E/(D+E)]

18. Copyright ©1999 Ian H. Giddy M&A 18 Estimating Market Value Weights l Market Value of Equity should include the following  Market Value of Shares outstanding  Market Value of Warrants outstanding  Market Value of Conversion Option in Convertible Bonds l Market Value of Debt is more difficult to estimate because few firms have only publicly traded debt. There are two solutions:  Assume book value of debt is equal to market value  Estimate the market value of debt from the book value  For Disney, with book value of $12.342 million, interest expenses of $479 million, and a current cost of borrowing of 7.5% (from its rating) Estimated MV of Disney Debt =

19. Copyright ©1999 Ian H. Giddy M&A 19 Estimating Cost of Capital: Disney l Equity  Cost of Equity =12.70%  Market Value of Equity = $50.88 Billion  Equity/(Debt+Equity ) = 82% l Debt  After-tax Cost of debt =7.50% (1-.36) =4.80%  Market Value of Debt = $ 11.18 Billion  Debt/(Debt +Equity) = 18% l Cost of Capital = 12.70%(.82)+4.80%(.18) = _____%

20. Copyright ©1999 Ian H. Giddy M&A 20 What’s IBM’s Cost of Equity? Its Cost of Capital? You have been asked to estimate the cost of capital for IBM. To help with this task you have been provided with a balance sheet (see below) and the following information: The beta of the stock is 1.09, based upon a regression of IBM stock returns against the S&P 500 Index. The share price is $130, and there are 943 million shares outstanding. The firm has $61.7 billion in debt on its balance sheet. Since the debt is mostly short-term or recently issued, one may assume that the book value of the debt provides a good approximation of its market value. IBM incurs a marginal corporate tax rate of 36%. The firm is rated A by the rating agencies, and the default spread over for A-rated 10-year bonds is currently 96 basis points over the corresponding US treasury yield. Ten year Treasurys currently yield about 4.40%, and the expected long-term return on the broad stock market is about 12%.

21. Copyright ©1999 Ian H. Giddy M&A 21 IBM’s Cost of Capital Cost of equity from the CAPM is: 4.40%+1.09(12%-4.40%) = 12.68% After-tax cost of debt is: Rate(1-Taxrate) = 5.36%(1-.36) = 3.43% The market value of equity is price*shares = $130*943 million = $122.59 billion. The debt, short- as well as long-term, is worth $61.7 billion. The sum of these is $184.29 billion. The weighted-average cost of capital is thus 12.68%(122.59/184.29+3.43%(61.7/184.29) = 9.59%

22. Copyright ©1999 Ian H. Giddy M&A 22 Value is Not Price l What is Intrinsic Value?  Self assigned Value  Variety of models are used for estimation l Market Price  What stock can be sold for or bought at l Trading Signal  IV > MP Buy  IV < MP Sell or Short Sell  IV = MP Hold or Fairly Priced More, less, or same as market portfolio?

23. Copyright ©1999 Ian H. Giddy M&A 23 Value is Not Price l What is Intrinsic Value?  Self assigned Value  Variety of models are used for estimation l Market Price  What stock can be sold for or bought at l Trading Signal  IV > MP Buy  IV < MP Sell or Short Sell  IV = MP Hold or Fairly Priced More, less, or same as market portfolio? When are a company’s shares undervalued?

24. Copyright ©1999 Ian H. Giddy M&A 24 Equity Valuation: From the Balance Sheet Value of Assets n Book n Liquidation n Replacement Value of Liabilities n Book n Market Value of Equity

25. Copyright ©1999 Ian H. Giddy M&A 25 Equity Valuation: From the Balance Sheet Value of Assets n Book n Liquidation n Replacement Value of Liabilities n Book n Market Value of Equity Book Value Liquidation Value Replacement Value Tobin’s Q: Market/Replacement tends to 1?

26. Copyright ©1999 Ian H. Giddy M&A 26 Discounted Cashflow Valuation: Basis for Approach  where  n = Life of the asset  CF t = Cashflow in period t  r = Discount rate reflecting the riskiness of the estimated cashflows

27. Copyright ©1999 Ian H. Giddy M&A 27 Equity Valuation versus Firm Valuation l Value just the equity stake in the business l Value the entire firm, which includes, besides equity, the other claimholders in the firm

28. Copyright ©1999 Ian H. Giddy M&A 28 I. Equity Valuation l The value of equity is obtained by discounting expected cashflows to equity, i.e., the residual cashflows after meeting all expenses, tax obligations and interest and principal payments, at the cost of equity, i.e., the rate of return required by equity investors in the firm. where, CF to Equityt = Expected Cashflow to Equity in period t ke = Cost of Equity l The dividend discount model (DDM) is a specialized case of equity valuation, and the value of a stock is the present value of expected future dividends.

29. Copyright ©1999 Ian H. Giddy M&A 29 II. Firm Valuation l The value of the firm is obtained by discounting expected cashflows to the firm, i.e., the residual cashflows after meeting all operating expenses and taxes, but prior to debt payments, at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value proportions. where, CF to Firm t = Expected Cashflow to Firm in period t WACC = Weighted Average Cost of Capital

30. Copyright ©1999 Ian H. Giddy M&A 30 Equity versus Firm Valuation l It is often argued that equity valuation requires more assumptions than firm valuation, because cash flows to equity require explicit assumptions about changes in leverage whereas cash flows to the firm are pre-debt cash flows and do not require assumptions about leverage. Is this true?  Yes  No

31. Copyright ©1999 Ian H. Giddy M&A 31 First Principle of Valuation l Never mix and match cash flows and discount rates. l The key error to avoid is mismatching cashflows and discount rates, since discounting cashflows to equity at the weighted average cost of capital will lead to an upwardly biased estimate of the value of equity, while discounting cashflows to the firm at the cost of equity will yield a downward biased estimate of the value of the firm.

32. Copyright ©1999 Ian H. Giddy M&A 32 Valuation: The Key Inputs l A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever. l Since we cannot estimate cash flows forever, we estimate cash flows for a “growth period” and then estimate a terminal value, to capture the value at the end of the period:

33. Copyright ©1999 Ian H. Giddy M&A 33 Stable Growth and Terminal Value l When a firm’s cash flows grow at a “constant” rate forever, the present value of those cash flows can be written as: Value = Expected Cash Flow Next Period / (r - g) where, r = Discount rate (Cost of Equity or Cost of Capital) g = Expected growth rate l This “constant” growth rate is called a stable growth rate and cannot be higher than the growth rate of the economy in which the firm operates. l While companies can maintain high growth rates for extended periods, they will all approach “stable growth” at some point in time. l When they do approach stable growth, the valuation formula above can be used to estimate the “terminal value” of all cash flows beyond.

34. Copyright ©1999 Ian H. Giddy M&A 34 Growth Patterns l A key assumption in all discounted cash flow models is the period of high growth, and the pattern of growth during that period. In general, we can make one of three assumptions:  there is no high growth, in which case the firm is already in stable growth  there will be high growth for a period, at the end of which the growth rate will drop to the stable growth rate (2-stage)  there will be high growth for a period, at the end of which the growth rate will decline gradually to a stable growth rate(3- stage) l The assumption of how long high growth will continue will depend upon several factors including:  the size of the firm (larger firm -> shorter high growth periods)  current growth rate (if high -> longer high growth period)  barriers to entry and differential advantages (if high -> longer growth period)

35. Copyright ©1999 Ian H. Giddy M&A 35 Length of High Growth Period l Assume that you are analyzing two firms, both of which are enjoying high growth. The first firm is Earthlink Network, an internet service provider, which operates in an environment with few barriers to entry and extraordinary competition. The second firm is Biogen, a bio-technology firm which is enjoying growth from two drugs to which it owns patents for the next decade. Assuming that both firms are well managed, which of the two firms would you expect to have a longer high growth period?  Earthlink Network  Biogen  Both are well managed and should have the same high growth period

36. Copyright ©1999 Ian H. Giddy M&A 36 Choosing a Growth Pattern: Examples CompanyValuation in Growth PeriodStable Growth Disney Nominal U.S. $10 years5%(long term Firm(3-stage)nominal growth rate in the U.S. economy Aracruz Real BR5 years5%: based upon Equity: FCFE(2-stage)expected long term real growth rate for Brazilian economy Deutsche BankNominal DM0 years5%: set equal to Equity: Dividendsnominal growth rate in the world economy

37. Copyright ©1999 Ian H. Giddy M&A 37 The Building Blocks of Valuation

38. Copyright ©1999 Ian H. Giddy M&A 38 Dividend Discount Models: General Model l V 0 = Value of Stock l D t = Dividend l k = required return

39. Copyright ©1999 Ian H. Giddy M&A 39 Specified Holding Period Model l P N = the expected sales price for the stock at time N l N = the specified number of years the stock is expected to be held

40. Copyright ©1999 Ian H. Giddy M&A 40 No Growth Model l Stocks that have earnings and dividends that are expected to remain constant l Preferred Stock

41. Copyright ©1999 Ian H. Giddy M&A 41 No Growth Model: Example E 1 = D 1 = $5.00 k =.15 V 0 = $5.00 /.15 = $33.33

42. Copyright ©1999 Ian H. Giddy M&A 42 Constant Growth Model l g = constant perpetual growth rate

43. Copyright ©1999 Ian H. Giddy M&A 43 Constant Growth Model: Example E 1 = $5.00b = 40% k = 15% (1-b) = 60%D 1 = $3.00 g = 8% V 0 = 3.00 / (.15 -.08) = $42.86 n Motel 6 has earnings of $5 per share. It reinvests 40% and pays out 60%dividend n The required return that shareholders expect is 15% n The earnings are expected to grow at 8% per annum n What’s an M6 share worth? n Motel 6 has earnings of $5 per share. It reinvests 40% and pays out 60%dividend n The required return that shareholders expect is 15% n The earnings are expected to grow at 8% per annum n What’s an M6 share worth? Plowback rate

44. Copyright ©1999 Ian H. Giddy M&A 44 Estimating Dividend Growth Rates l g = growth rate in dividends l ROE = Return on Equity for the firm l b = plowback or retention percentage rate i.e.(1- dividend payout percentage rate)

45. Copyright ©1999 Ian H. Giddy M&A 45 Shifting Growth Rate Model l g 1 = first growth rate l g 2 = second growth rate l T = number of periods of growth at g 1

46. Copyright ©1999 Ian H. Giddy M&A 46 n Mindspring pays dividends $2 per share. The required return that shareholders expect is 15% n The dividends are expected to grow at 20% for 3 years and 5% thereafter n What’s a Mindspring share worth? n Mindspring pays dividends $2 per share. The required return that shareholders expect is 15% n The dividends are expected to grow at 20% for 3 years and 5% thereafter n What’s a Mindspring share worth? Shifting Growth Rate Model: Example D 0 = $2.00 g 1 = 20% g 2 = 5% k = 15% T = 3 D 1 = 2.40 D 2 = 2.88 D 3 = 3.46 D 4 = 3.63 V 0 = D 1 /(1.15) + D 2 /(1.15) 2 + D 3 /(1.15) 3 + D 4 / (.15 -.05)(1.15) 3 V 0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40

47. Copyright ©1999 Ian H. Giddy M&A 47 Relative Valuation l In relative valuation, the value of an asset is derived from the pricing of 'comparable' assets, standardized using a common variable such as earnings, cashflows, book value or revenues. Examples include -- Price/Earnings (P/E) ratios q and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples) Price/Book (P/BV) ratios q and variants (Tobin's Q) Price/Sales ratios

48. Copyright ©1999 Ian H. Giddy M&A 48 Ratios Do Have Meaning l Gordon Growth Model: l Dividing both sides by the earnings, l Dividing both sides by the book value of equity, l If the return on equity is written in terms of the retention ratio and the expected growth rate l Dividing by the Sales per share,

49. Copyright ©1999 Ian H. Giddy M&A 49 Price Earnings Ratios l P/E Ratios are a function of two factors  Required Rates of Return (k)  Expected growth in Dividends l Uses  Relative valuation  Extensive Use in industry

50. Copyright ©1999 Ian H. Giddy M&A 50 Disney: Relative Valuation CompanyPEExpected GrowthPEG King World Productions10.47.00%1.49 Aztar11.912.00%0.99 Viacom12.118.00%0.67 All American Communications15.820.00%0.79 GC Companies20.215.00%1.35 Circus Circus Enterprises20.817.00%1.22 Polygram NV ADR22.613.00%1.74 Regal Cinemas25.823.00%1.12 Walt Disney27.918.00%1.55 AMC Entertainment29.520.00%1.48 Premier Parks32.928.00%1.18 Family Golf Centers33.136.00%0.92 CINAR Films48.425.00%1.94 Average27.4418.56%1.20 PE ratio divided by the growth rate

51. Copyright ©1999 Ian H. Giddy M&A 51 Estimating Future Cash Flows n Dividends? n Free cash flows to equity? n Free cash flows to firm?

52. Copyright ©1999 Ian H. Giddy M&A 52 Disney Valuation l Model Used:  Cash Flow: FCFF (since leverage will change over time)  Growth Pattern: 3-stage Model (even though growth in operating income is only 10%, there are substantial barriers to entry)

53. Copyright ©1999 Ian H. Giddy M&A 53 Free Cash Flows to the Firm EBIT (1-t) + Depreciation & Amortization - Capital Expenditures - Change in Working Capital = FCFF

54. Copyright ©1999 Ian H. Giddy M&A 54 Cash Flow to Firm ClaimholderCash flows to claimholder Equity InvestorsFree Cash flow to Equity Debt HoldersInterest Expenses (1 - tax rate) + Principal Repayments - New Debt Issues Preferred StockholdersPreferred Dividends Firm =Free Cash flow to Firm = Equity InvestorsFree Cash flow to Equity + Debt Holders+ Interest Expenses (1- tax rate) + Preferred Stockholders+ Principal Repayments - New Debt Issues + Preferred Dividends

55. Copyright ©1999 Ian H. Giddy M&A 55 Disney: Inputs to Valuation

56. Copyright ©1999 Ian H. Giddy M&A 56 Disney: Costs of Capital

57. Copyright ©1999 Ian H. Giddy M&A 57 Estimating FCFF Disney l EBIT = $5,559 Million l Capital spending = $ 1,746 Million l Depreciation = $ 1,134 Million l Non-cash Working capital Change = $ 617 Million l Estimating FCFF EBIT (1-t) $ 3,558 + Depreciation $ 1,134 - Capital Expenditures $ 1,746 - Change in WC $ 617 = FCFF $ 2,329 Million

58. Copyright ©1999 Ian H. Giddy M&A 58 Disney: FCFF Estimates

59. Copyright ©1999 Ian H. Giddy M&A 59 Disney: Terminal Value l The terminal value at the end of year 10 is estimated based upon the free cash flows to the firm in year 11 and the cost of capital in year 11. l FCFF 11 = EBIT (1-t) - EBIT (1-t) Reinvestment Rate = $ 13,539 (1.05) (1-.36) - $ 13,539 (1.05) (1-.36) (.3125) = $ 6,255 million l Note that the reinvestment rate is estimated from the cost of capital of 16% and the expected growth rate of 5%. l Cost of Capital in terminal year = 10.19% l Terminal Value = $ 6,255/(.1019 -.05) = $ 120,521 million

60. Copyright ©1999 Ian H. Giddy M&A 60 Disney: Present Value

61. Copyright ©1999 Ian H. Giddy M&A 61 Is Disney fairly valued? l Based upon the PE ratio, is Disney under, over or correctly valued?  Under Valued  Over Valued  Correctly Valued l Based upon the PEG ratio, is Disney under valued?  Under Valued  Over Valued  Correctly Valued l Will this valuation give you a higher or lower valuation than the discounted CF valuation?  Higher  Lower

62. Copyright ©1999 Ian H. Giddy M&A 62 Relative Valuation Assumptions l Assume that you are reading an equity research report where a buy recommendation for a company is being based upon the fact that its PE ratio is lower than the average for the industry. Implicitly, what is the underlying assumption or assumptions being made by this analyst?  The sector itself is, on average, fairly priced  The earnings of the firms in the group are being measured consistently  The firms in the group are all of equivalent risk  The firms in the group are all at the same stage in the growth cycle  The firms in the group are of equivalent risk and have similar cash flow patterns  All of the above

63. Copyright ©1999 Ian H. Giddy M&A 63 M&A Valuation l Value each company separately l Estimate the value from control l Estimate the value from synergy l How would you value the combined company? l Where do you think value added would come from in this merger? l What should Company A offer for Company B?

64. Copyright ©1999 Ian H. Giddy M&A 64 Case Study: Optika-Schirnding Questions: l How would you value Optika? l How would you value Schirnding? l How would you value the combined company?

65. Copyright ©1999 Ian H. Giddy M&A 65 Optika CAPM: 7%+1(5.50%) Debt cost (7%+1.5%)(1-.35) WACC: ReE/(D+E)+RdD/(D+E) Value: FCFF/(WACC-growth rate) Equity Value: Firm Value - Debt Value = 2680-250 = 2430 2680

66. Copyright ©1999 Ian H. Giddy M&A 66 Optika & Schirnding 2680

67. Copyright ©1999 Ian H. Giddy M&A 67 Optika-Schirnding with Synergy 2680

68. Copyright ©1999 Ian H. Giddy M&A 68 Case Study: Compaq-DEC Questions: l How would you value DEC? l How would you value Compaq? l How would you value the combined company? l Where do you think value added woul come from in this merger? l What should Compaq offer for Digital?

70. n www.stern.nyu.edu

71. www.giddy.org

73. Copyright ©1999 Ian H. Giddy M&A 73 www.giddy.org Ian Giddy NYU Stern School of Business Tel 212-998-0332; Fax 212-995-4233 ian.giddy@nyu.edu http://www.giddy.org