1. - - - - - - - - Chapter 9 - - - - - - - -
Alternative Approaches to Valuation
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2. Introduction Valuation critical in M&As
Framework essential to discipline valuation estimates
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3. Comparable Companies Method
Group of companies comparable with respect to:
Size
Products
Recent trends and future prospects
Key ratios are calculated for each company
Key ratios are averaged for group
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4. Average ratios applied to absolute data for company of interest
Indicated market values obtained from each ratio
Valuation judgments are made
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5. Advantages Limitations Common sense approach
Marketplace transactions are used
Widely used in legal cases, fairness evaluation, and opinions
Used to value a company not publicly traded
Limitations
May be difficult to find companies that are actually comparable by key criteria
Ratios may differ widely for comparable companies
Different ratios may give widely different results
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6. Comparable Transactions Method
Valuation based on companies involved in the same kind of merger transactions
Market value refers to transactions in a completed deal
More directly applicable than company comparisons
May be difficult to find truly similar transactions within a relevant time frame
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7. Spreadsheet Approach to Valuation and Mergers
Procedure
Historical data for each element of balance sheet, income statement, and cash flow statement are presented — 7 to 10 years
Detailed financial analysis is performed to discover financial patterns
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8. Based on analysis, relevant cash flows are projected
Additional analysis
Business economics of industry in which company operates
Company's competitive position
Assessments of financial patterns, strategies, and actions of competitors
Based on analysis, relevant cash flows are projected
Procedures similar to capital budgeting analysis
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9. Capital budgeting decisions
Process of planning expenditures whose returns extend over a period of time
An acquisition is fundamentally a capital budgeting problem: Mergers do not make sense if buyer pays too much resulting in negative NPVs
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10. Spreadsheet projections
Provide great flexibility in projections
Important to understand underlying growth patterns
NPV of acquisition obtained from sum of free cash flows discounted at applicable cost of capital
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11. Advantages of spreadsheet approach
Expressed in financial statements
Any desired detail of individual balance sheet or income statement accounts
Flexibility and judgment in formulating projections
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12. Disadvantages of spreadsheet approach
Numbers used in projections may create illusion that they are actual or correct numbers
May lack link between projected numbers and business logic
May become highly complex
Details may obscure important driving factors
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13. Formula Approach
No real distinction between spreadsheet approach and formula approach
Both use discounted cash flow analysis
Spreadsheet approach expressed in form of financial statements over period of time
Formula approach summarizes same data in compact form
Formula approach helps focus on underlying drivers of valuation
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14. Development of compact valuation formulas
Valuation necessarily requires forecasts
Usually assumes systematic relations between time periods, variables
Key variables and relationships
Revenues (Rt)
Basic driver of a firm's value
Market value to revenue multiples usually calculated for comparing values of firm in same industry
Main approach to valuing Internet stocks
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15. Growth rate (g)
Defined as rate of change in revenues
Growth rate will mirror various combinations of cash flow patterns that reflect ebb and flow of strategic and competitive factors
Net operating income margin (m) after deducting operating costs from revenues including:
Cost of goods sold
Selling, general, and administrative expenses
Depreciation expenses
Actual tax rate (T)
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16. Number of periods of supernormal growth (n)
Investment (It)
Investment as a ratio of revenues
Defined as the change in total capital over the previous period
Change in total capital
Investment in working capital, gross or net
Investment in fixed assets, gross or net
Number of periods of supernormal growth (n)
Defined by firm's competitive advantage
Supernormal growth period will end when competition erodes the firm's competitive advantage
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17. Marginal weighted cost of capital (k)
Cost of equity
After-tax cost of debt
Weighted average of the two based on target financing proportions
Value drivers for net operating income margin (m) and investment (I) are expressed as a percentage of sales — could be obtained through a linear regression relationship with revenues
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18. Sensitivity analysis Purpose Sensitivity analysis of model variables:
Check impact of a range of alternative possibilities
Provide framework for planning and control
Sensitivity analysis of model variables:
Decrease in revenues growth rate (g) lowers valuation
Increase in investment requirement percentage (I) lowers valuation
Operating profit margin (m) is a powerful value driver — when m is increased, valuation increases
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19. Valuation is very sensitive to the cost of capital (k) used in analysis — when cost of capital is increased, valuation falls
Sensitivity to n and T predictable in direction and magnitude
When period of supernormal growth is reduced, valuation is reduced
When tax rate is reduced, valuation is increased
In many practical cases, second term in valuation model represents a higher proportion of valuation than first term — must be careful as to assumptions about factors affecting exit or terminal value
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20. Limitations of the formula approach
Less flexibility in reflecting forecasts for individual years
Calculations use financial statement data not directly shown in the formulas
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21. Cost of Capital Measurement
Steps involved in calculation of cost of capital
Calculate cost of equity capital
Calculate cost of debt
Formulate applicable financial structure or financial proportions
Apply applicable financial proportions to cost of equity and cost of debt
Final result is weighted cost of capital
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22. Cost of equity Capital Asset Pricing Model (CAPM)
ks = Rf + [RM - Rf] j
Risk-free rate (Rf)
Related to returns on U.S. government bonds
Rates on relatively long-term bonds should be used since discount factor is used in valuation involving long periods
Market price of risk (RM - Rf)
For many years, estimated to be in range of 6.5 to 7.5%
For new economic paradigm since mid 1990s, estimated to be in the range 4% to 5%
Beta (j )
Measures how returns on the firm's common stock vary with returns on the market as a whole
High beta stocks exhibit higher volatility than low beta stocks in response to changes in market returns
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23. Dividend growth model
Cost of equity based on the constant-growth dividend valuation model
Required return on equity is expected dividend yield (D1/S0) plus expected growth rate of dividends in perpetuity (g)
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24. Bond yield plus equity risk premium
Cost of equity = Average yield to maturity of bonds for the industry with same rating as the firm's debt + historical average firm's equity risk premium over its bond yield
For the industry, analyze historical yield on equity as compared with average yield to maturity on bonds for the industry
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25. Estimating the cost of equity capital
Use information generated by financial markets
Estimate cost of equity using multiple methods
Consider general equity market uncertainty
Consider estimates for other companies in same industry
Use judgment to arrive at an estimate
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26. Cost of debt
Cost of debt calculated on an after-tax basis because interest payments are tax deductible
After-tax cost of debt = kb(1 - T )
Before-tax cost of debt, kb
Can be obtained from a weighted average of the yields to maturity of all the firm's outstanding publicly held bonds
Can be obtained from published promised yields to maturity based on bond rating category
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27. Weighted cost of capital
Cost of capital, k, is weighted average of marginal cost of equity and debt
k = kb(1-T)(B/V)+ks(S/V) where:
kb = cost of debt ks = cost of equity T = tax rate B = value of debt S = value of equity V = total value of firm = B + S or
k = ku(1-TL) where:
ku = cost of capital of an unlevered firm
L = B/V
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28. May use book or market values to provide guidelines
Methodology focuses on current market opportunity costs, not book or historical costs
May use book or market values to provide guidelines
Use judgment to estimate target financial proportions
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29. Merger premiums
It is wrong to conclude that number of shares paid in a stock-for-stock deal is unimportant just because it is a paper-for-paper deal
Premium paid decides the percentage of combined ownership each party to the merger will control
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30. Higher premium paid:
Greater the percentage ownership of the new firm by the shareholders of the acquired firm
Greater the value per share dilution for acquirer shareholders
Greater the EPS dilution for acquirer shareholders
Presence of merger economies from synergies, cost savings, etc. can recover acquirer premiums paid, could even make mergers accretive
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31. Summary All valuation methods have strengths and weaknesses
Employ multiple methods of valuation in takeover analysis
Valuation should be guided by a business economics outlook for the firms
Ultimately judgments are required for valuations
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