1. - - - - - - - - Chapter 10 - - - - - - - -
Increasing the Value of the Organization
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2. Multiple Approaches to Valuation are Illustrated by Case Examples
Mergers in oil industry in the 1980s (Chevron-Gulf)
Mergers in oil industry of the 1990s (Exxon-Mobil)
Firm valuation through the stages in the life cycle
Valuations in the Internet industry
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3. Oil Mergers of the Early 1980s (Chevron/Gulf)
Transaction terms
Chevron won auction in March 1984
Cash bid of $80 per share
Pretakeover activity price of Gulf was $39
Premium was $41 or 105%
Gulf had million shares, total price was $13.2 billion — a gain of $6.8 billion
Transaction was taxable and treated as a purchase
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4. Event returns
Chevron had a positive event return of $2 billion for the period between February 1984 and May 1984
Gulf positive event return gain was about $6.8 billion
Total positive event return was $8.8 billion
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5. Comparable transaction analysis
In five prior oil company acquisitions the weighted average ratios were calculated
Transaction value to book equity 2.35
Transaction value to EBITDA 3.05
Transaction value to revenues 0.75
Transaction value to market equity 1.34
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6. Application of the multiples gave an average value of Gulf of $16
Application of the multiples gave an average value of Gulf of $16.1 billion
This benchmark indicates that the $13.2 billion price was fair
Further analysis is required
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7. The Value of Gulf, 1983 Formula method
The value drivers for Gulf were:
Actual tax rate (T) = 50%
Marginal cost of capital (k) = 13.1%
Risk free rate = 8.0%
Market price of risk = 7.5%
Yield to maturity (YTM) of AA-rated debt = 10%
Leverage ratio = 30%
Initial EBIT (1983) (X0) = $2,990 m
Gulf's EBIT had been flat at $2.99 billion for previous 10 years — assume no growth company
Valuing Gulf as a no growth company gives $11.5 billion
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8. Finding costs analysis
The returns from Gulf's exploration and development (E&D) programs in the early 1980s were negative
By stopping E&D programs, Gulf could have avoided losses with a capitalized value of $50.36/share based on a cost of capital of 17%.
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9. Added to the then current market value of common stock at $39 gives a total of $89 per share, supporting the $80 per share price paid by Chevron.
Calculations based on a cost of capital of 13% resulted in a loss per barrel of $42.10 from E&D program. Added to the market value of common stock gives a total of $81 per share.
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10. Other approaches to the valuation of Gulf
Chevron purchased Gulf's reserves of 2,313 million barrels equivalent
Price of oil fluctuated between $10 and $31.75 per barrel
Using $10 per barrel, Gulf's reserves were worth $23.13 billion — far above the $13.2 billion Chevron paid.
The different valuation approaches indicate that Chevron's purchase of Gulf at $13.2 billion was a positive NPV investment
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11. Valuation and Merger Analysis General Framework
Nature of the industry
Industry characteristics that drive mergers and potential synergies
Historical value drivers
Business economic analysis of the future for the industry and firms
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12. Projections of the value drivers for valuation firms
Effects of the merger or rival competitive structure and strategies
Antitrust and other regulatory aspects
Implementation
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13. Exxon-Mobil Merger Characteristics of the oil industry
Basic characteristics
Oil is a global market
Strategically important for industrial, political, and military reasons
Large costs required for environmental protection
Impact of OPEC
High degree of price instability
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14. Setting for oil industry mergers in 1997-1999
Price fluctuations — from $25 per barrel in 1996 to $9 per barrel by early 1999 to $24 per barrel in September 1999; $35 in early 2000; $26 in May 2000
Restructuring, investment in technology, and cost reduction
Oil industry characterized by cash flows in excess of positive NPV investment opportunities
Oil companies tried diversification in 1980s which resulted in declines in shareholder values
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15. Companies restructured by selling off unrelated businesses in early 1990s
Invested in improved technologies — increased oil field recovery by more than 50%
Finding costs for 20 largest companies dropped from over $20 per barrel of oil equivalent in to less than $5 by
Lifting costs including taxes dropped to $4.60 per barrel for onshore activity and $4.19 for foreign activity by 1997
Production costs dropped from $7.20 per barrel in the mid-1980s to $4.10 by 1990
Gains from cost reductions helped oil companies achieve profitability at oil prices in the $16 to $18 per barrel range but gains leveled off in the 1990s
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16. Uneven market adjusted returns to shareholders
Net market adjusted shareholder returns were positive for BP and Exxon in the five- and three-year periods prior to 1999
Returns were negative for other major oil companies
Mobil, ARCO, and Amoco significantly underperformed the benchmark
Oil group underperformed the broader market index
Statistically significant relationship between revenues and shareholders returns - largest companies were the lowest cost producers
M&A activities were an effort by oil companies to increase efficiencies, to reduce costs, to invest in new technologies, and to seek new profitable investment opportunities
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17. Reasons for the Exxon-Mobil merger
Would extend presence in regions of the world with highest potential for future oil and gas discoveries and production
Stronger position to invest in large outlay programs with high prospective returns and risk
Complementary exploration and production operations in South America, Russia, Eastern Canada, Asia, and Africa
Near-term operating synergies in the amount of $2.8 billion
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18. Valuation analysis of the Exxon-Mobil merger
Premerger market value — Exxon: $175 billion, Mobil: $58.7 billion
Premerger price per share — Exxon $72; Mobil $75.25
Terms of 1.32 Exxon shares for each share of Mobil; (1.32)($72) = $95.04
$95.04 x 780 million Mobil shares = $74.13 billion paid or ($74.13/$58.7) = 26.3% premium over Mobil premerger market cap
Premerger, Exxon shares represented 75% of combined market value
Postmerger, Exxon shares represented 70% of combined market value
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19. Cost of capital for Exxon and Mobil
Cost of equity
Betas
Value Line estimates — Exxon: 0.85, Mobil: 0.75
Beta below 1.0 — oil companies are greatly influenced by policies of OPEC nations as well as returns on the market
Long-term treasuries: 6% range
Market equity risk premium: 5%
Cost of equity capital
Exxon = 6% + (5%)(0.85) = 10.25%
Mobil = 6% + (5%)(0.75) = 9.75%
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20. Debt to total firm value = 30%, Equity to total firm value = 70%
Cost of debt
Exxon
AAA bond rating
Yield to maturity (YTM): 120 basis points (bp) above treasuries
Before-tax cost of debt = 7.2%
Mobil
AA bond rating
YTM: 20 to 30 bp over AAAs
Before-tax cost of debt = 7.5%
Debt to total firm value = 30%, Equity to total firm value = 70%
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21. Cash tax rates: Exxon = 35%, Mobil = 40% Weighted cost of capital
Combined firm in range of 8.3% to 8.5%
Company risks reduced
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22. Premium recovery Dilution/accretion analysis No synergies
Exxon: dilution of 6.2% of share price
Mobil: accretion of 18.5% of share price
Estimated synergies between $3 to $6 billion per year
Exxon experiences accretion between 8.1% and 22.5%
Mobil experiences accretion between 36.6% and 54.7%
Exxon experiences accretion if synergies are over $2 billion
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23. Value driver analysis Value drivers
Next year revenues — Exxon: $150 billion, Mobil: $75 billion
Revenues growth rate — Exxon: 10%, Mobil: 10%
Net operating margin — Exxon: 7.9%, Mobil: 5.9%
Actual cash basis tax rates — Exxon: 35%, Mobil: 40%
Cost of capital — Exxon: 8.6%, Mobil: 8.2%
Competitive advantage period = 15 years
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24. Stand-alone firms Combined firms Exxon Mobil
Estimated value per share = $73.25
Actual premerger price = $72
Mobil
Estimated value per share = $70.66
Actual premerger price = $75.25
Combined firms
Net operating income margin (m) = 8.1%
Weighted (by revenues) average m = 7.2%
Add estimated synergy gains of $2 billion or 0.9% of revenues
Estimated combined equity value = $281 billion or $80.82 per share
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25. Sensitivity analysis Elasticities of response in value drivers
Positive — initial level of revenues, growth rate in revenues, net operating income margin, and period of competitive advantage
Negative — tax rate, cost of capital, and investment requirements
Role of sensitivity analysis
Enables decision maker to identify relative power of value drivers on the firm valuation
Provides a planning framework for improving firm performance related to value drivers
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26. Test of merger performance
Value of combined company = $281 billion
Amount paid to Mobil = $74 billion
Remainder = $207 billion
Exxon premerger value = $175 billion
Gain from merger = $32 billion
Gain allocation
Exxon shareholders own 70% of combined company or $22.4 billion of the merger gains
Mobil shareholders own 30% of combined company or $9.6 billion of merger gains plus premium received of $15 billion for a total $24.6 billion of value added to their shares
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27. Comparison of premium paid with expected target improvement
Rappaport (1998)
Calculates value of Duracell as a stand-alone company and its change in value resulting from combination with Gillette
Improvement in value results from operating synergies
Critique
Potential synergies can also involve interdependencies between target and acquirer
Improvement analysis should consider combined companies rather than target alone
Large premiums paid may appear impossible to overcome if one considers only value increases for the target alone
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28. Event analysis Event date 0 was announcement date on 12/1/98
Excess returns with respect to AMEX Oil Index
CAR for event window [-10,0]
Mobil = 16.2%
Exxon = 0.97%
CAR for event window [-10,+10]
Mobil = 23.7%
Exxon = 6.3%
Positive CARs consistent with calculation of $32 billion added value from the merger
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29. Antitrust issues Herfindahl-Hirschman Index (H Index) measure
H index for petroleum industry
1975, H index = 410
1979, H index = 416
1984, H index = 377
1990, H index = 362
1995, H index = 407
1996, H index = 415
H index well under critical 1,000 level specified in regulatory Guidelines
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30. Effects of major oil mergers on H index
Major oil combinations
Total/Petrofina: increase index by 6.13 points to
Total Fina/Elf Aquitane: increase index by points to
BP/Amoco: increase index by points to
Exxon/Mobil: increase index by points to
BP Amoco/ARCO: increase index by 51.1 points to
If a Chevron/Texaco took place: increase index by points to
Six mergers among top 23 petroleum companies in the world would result in a rise of H index from 389 to 599, well short of 1,000 critical level
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31. Overall industry concentration measures are far below 1,000 threshold
Antitrust issues are not raised from an aggregate industry standpoint
Although individual oil companies are large, oil industry is also large ($1.5 trillion revenues)
Federal Trade Commission required Exxon-Mobil to sell off some wholesale distribution and retail marketing entities
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32. Emerging competitive forms in the oil industry
Integrated oil firms compete in traditional areas of oil and gas exploration and production, refining, and marketing
Integrated oil firms have significant penetration in chemical industry
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33. Competitive pressures on firms in energy industry
Lower cost structures of megafirms
New low-priced supply quantities from improvement in technology and cost structures
Convergence of markets
Deregulation
Divestitures resulting from tighter focus
Competitive responses
Relationships, alliances, joint ventures, focus
Specialization
Other mergers
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34. Valuation in the Framework of Product Life Cycles
Industry product life cycle
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35. Value drivers Growth rates (g) Net operating income (NOI/Revenue)
Highest for Stage I
Decline as the industry progresses through the product life cycle
Could become negligible, zero, or negative for industries in decline
Net operating income (NOI/Revenue)
Small or negative for the first stage
Profit rates rise sharply as industry moves into a volume of revenues that demonstrate a solid future
Profit rates decline as industry matures
NOI margin becomes zero or negative for industry in decline
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36. Investment requirement (I)
In Stage I, external investment requirements are low because of heavy reliance on supplier financing
At the stage at which some firms in the industry are well launched, external financing requirements will be high
As the industry matures, investment requirements decline
Investment requirements may become negligible or zero in declining industries
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37. Number of years of competitive advantage (N)
Expected competitive advantage for firms with sound strategic basis, launched in Stage I, has potential to be sustained for a long period of time
As industry matures, competitive advantage declines and the expected number of years shortens
Competitive advantage is negligible or non-existent in industries in decline
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38. Cost of capital (k)
Companies in early stages experience high cost of capital because of high uncertainties in the industry
Cost of capital declines with each successive stage
In later stages VI and VII, cost of capital may increase as uncertainty increases again as decline and renewal or restructuring are experienced
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39. (r - k) r = marginal profitability rate k = cost of capital
Larger positive difference between r and k implies:
Greater ratio of market value of an investment (firm as a whole) and investment cost
Greater market to book ratio
Greater q-ratio
Spread by which r exceeds k highest in Stage II and declines in successive stages, becoming zero or negative as the stage of decline is reached
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40. Marginal investment requirements (b)
Investment requirements (opportunities) normalized by after tax cash flows
Gives a measure of amount by which investment requirements will have to be financed from sources other than current year cash flows
Pattern similar to investment requirement value driver
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41. Measure of incremental value creation = (r - k) I Comments
Product of marginal profitability rate (r) and marginal investment requirement rate (b) is always equal to the growth rate (g)
Measure of incremental value creation = (r - k) I
Comments
Stages of industry's development have a major influence on value drivers of prospective merger partners but not deterministic
Industry product life cycle perspective provides first step for understanding of valuations in industries in different stages of their life cycles
Variations are present among firms in the same industry
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42. The Internet and Online Technologies
Background
Revolutionary distribution vehicle
Global market
High growth rates
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43. Financial characteristics
High volatility in stock prices
High stock prices relative to revenues because of high prospective growth rates
Internet retailers can earn returns on invested capital comparable to traditional retailers with gross operating margins in the 5 to 10% range vs. 20 to 30% because of lower investment requirements
Use of M&As
Proceeds and stocks from new Internet IPOs used for rapid series of acquisitions
Aim is to achieve critical mass, market leadership, and name recognition
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44. Valuation approaches Comparable companies approach
Ratio of market to EBITDA may not work because of low or negative EBITDAs
Ratio of market to book may be distorted because losses depress size of book values
Ratio most widely used is market to revenues
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45. DCF valuation
Standard DCF methodology with multiple stages of revenue growth can explain valuation relationships observed for Internet companies
Illustration of a 4-stage DCF valuation model
Stage 1
Losses in early years
High revenue growth rate above 50%
Negative operating margins
Zero tax rate
High cost of capital of 15%, reflecting high beta risks
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46. Company has matured sufficiently to achieve profitability
Stage 2
Company has matured sufficiently to achieve profitability
Period of favorable growth and high margins
Growth rate drops to around 33%
Operating margins rise to 30%
Tax rate around 20% to reflect benefit of carryforward of tax losses in Stage 1
Cost of capital remains relatively high
Stage 3
Revenue growth decays until it reaches 3%
Operating margin declines to 15%
Combined corporate tax (federal and state) of 40%
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47. Stage 4
Constant or no growth rate
Operating margins decline further to 10%
Tax rate and cost of capital at same level as in Stage 3
Variations in the value drivers can be made to reflect different scenarios
High multiples of market to revenues observed in Internet companies reflect high growth and high profit margins achievable in early stages of new industries
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48. Calculating Growth Rates
Discrete compound annual growth rate (d)
Geometric average based on the end points of the time series
Found by dividing the final year number (Xn) by the initial year figure (X1), then taking the n-th root (for n number of years between initial and final number)
May be seriously flawed if end values are not representative of fluctuations in the time series of the variable
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49. Continuously compounded growth rate (c)
Estimated from regression
ln(Xt) = a + bt where
ln(Xt) = natural log of variable X t = time in annual periods
Continuous compounded growth rate, c, for variable X c = b' = estimated slope coefficient of regression
Regression method considers fluctuations; takes into account all data points
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50. Relation between discrete and continuously compounded rate
d = ec - 1 where e = the base of the natural system of logarithms =
c = ln(1+d)
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