EF4312 Mergers and Acquisitions Chapter 14 Target Valuation

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EF4312 Mergers and Acquisitions Chapter 14
Target Valuation

• Prof. Stephen Cheung
• Department of Economics and Finance
• City University of Hong Kong

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Learning Objectives

• At the end of this chapter, you should be able to
  understand
  
• The traditional earnings, assets and cash
  flow-based models, their conceptual bases and
  assumptions
  
• The value drivers in earnings, asset and cash
  flow-based models and how they are influenced by
  the underlying economics of the acquisition
  
• Non-traditional multiples as valuation models
• The concepts of real options, strategic
  adaptability and managerial flexibility
  
• The difference between traditional models and
  real option models and
  
• The limitations of the models and the caveats in
  using them for acquisition pricing.

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Key Concepts and Points

• This chapter begins the third stage of our
  5-stage model of M A, Deal structuring and
  negotiation
  
• Target valuation important step in determining
  the offer price for a target firm and in
  structuring and negotiating deal
  
• Value the bidder places on target sets the
  maximum or walk away price

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Key Concepts and Points

• Value of target to bidder pre-bid stand-alone
  value of target value bidder expects to add
  
• Target valuation is valuation of the incremental
  cash flows to both target and acquirer as a
  result of the acquisition
  
• Valuation based on expectation of magnitude and
  timing of realization of anticipated benefits

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Key Concepts and Points

• Valuation is imprecise on either score and this
  increases valuation risk to bidder
  
• Number of models available to value targets
• Earnings and assets
• Cash flows
• Real options i.e. the value of future growth
  opportunities the acquisition will generate
  

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Key Concepts and Points

• Sources of value in acquisitions
• Value added by acquirer value from operating
  efficiencies revenue enhancement real
  options
  
• Traditional valuation models
• Abnormal earnings models
• These models first estimate future earnings,
  subtract the cost of using the assets that
  generate these earnings and discount these excess
  or abnormal earnings at relevant cost of capital
  (COC) to arrive at target value

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Key Concepts and Points

• Equity value
• where NIt net income for equity holders for
  year t and Ke equity COC. BEt book value of
  equity.
  
• Asset value sum of the capital from equity and
  debt. Formula uses after tax profit for both
  these capital providers rather than just net
  income for equity.

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Key Concepts and Points

• Asset value
• where NOPt Net operating profit after tax
  (NOPAT) for year t and Kw weighted average cost
  of equity and debt (WACC). BAt book value of
  equity and assets represented by sum of equity
  and debt at beginning of year t.

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Key Concepts and Points

• Interpretation of formulae
• Equity (asset) value equals book value of assets
  in place plus the value due to future growth, at
  a rate of return in excess of dollar COC.
  
• Growth component specifies conditions under which
  growth creates value.
  
• Profit made by the company, Net Income (NI), must
  exceed the opportunity cost of using the assets
  for equity, Ke . BEt.

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Key Concepts and Points

• Profit made by the company from all assets, NOP,
  should exceed the opportunity cost of using them,
  Kw . BAt.
  
• If assets do not generate returns in excess of
  the relevant COC, there is no value addition.
  

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Key Concepts and Points

• Under what competitive conditions can acquirer
  generate returns in excess of COC?
  
• Growth component can extend over several years.
• Each growth term on right hand side represents
  value addition from maintaining the competitive
  edge in that year.
  
• Competitive equilibrium reached when profit
  equals dollar COC.
  
• Value destruction happens when profit fails to
  match the latter.
  

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Key Concepts and Points

• Equity value to book value of equity (EVBV)
• where ROEt is return on equity NIt / BEt-1 and
  gt is percentage growth in book value of equity
  BE from t-1 to t.
  

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Key Concepts and Points

• Firm has equity to book value of 1 when ROE
  equals COC in every period.
  
• Suppose company As ROE is 10 and its equity COC
  is 15.
  
• It does not generate any value and its equity to
  book value less than 1.
  
• Acquirer of A able to improve its performance and
  its ROE and deliver shareholder value.
  
• Similar formula for Equity plus debt to book
  value of total assets.
  

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Key Concepts and Points

• Return on assets ROA should exceed WACC in every
  period in the future.
  
• With competition eroding profit margins, ROE
  (ROA) and growth rate g decline over time
  competitive attrition of profitability
  
• Price/ earnings ratio, also called earnings
  multiple, concerns relation between a firms
  earnings for equity, NI, and its market
  capitalization

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Key Concepts and Points

• Price/earning ratio
• Interpretation of the PER
• Level future equity earnings of the firm.
• Investors expected return for equity investment
  in firm i.e. the equity COC related to riskiness
  of firms earnings, Ke
  
• Expected return on the investments made by the
  firm, ROE.
  
• Length of time firm can earn returns on its
  investments in excess of the investor-required
  return i.e. the speed to establishment of
  competitive equilibrium.

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Key Concepts and Points

• Estimating target value using PER model
• 1. Examine the most recent profit performance of
  the target firm and the expected future
  performance under the current target management.
  
• 2. Identify those elements of revenue and costs
  which will be raised or lowered under the
  acquirer management.

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Key Concepts and Points

• 3. Re-estimate the targets future,
  post-acquisition earnings for equity shareholders
  on a sustainable basis. These earnings are known
  as sustainable or maintainable earnings.
• 4. Select a benchmark PER.
• 5. Multiply the sustainable earnings by the
  benchmark PER to arrive at a value for equity.
  
• Example of valuation using PER

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Key Concepts and Points

• Limitations of PER model
• Estimates post-acquisition earnings for target
  for one period, and assumes this level will be
  maintained.
  
• No explicit recognition of the time pattern of
  earnings growth.
  
• Does not explicitly consider the
  investor-perceived risk of the target firms
  earnings.
  
• Problems in selection of benchmark PER
• Despite limitations, model provides valuation
  based on capital market consensus view of value
  of earnings.
  
• Widely used by the investment community.

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Key Concepts and Points

• Enterprise value multiple (EVM)
• Enterprise value /earnings before interest and
  tax (EV/EBIT)
  
• Its cash flow variant Enterprise value/
  earnings before interest, tax, depreciation and
  amortisation (EV/EBITDA)
  
• EBIT pre-tax return to both shareholders and
  debt holders
  
• Since most firms funded by equity and debt, sum
  of equity and debt values value of the firm or
  enterprise.
  

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Key Concepts and Points

• Adding back non-cash expenses depreciation and
  amortisation, EBITDA operating cash flow.
  
• EVM widely used by investment analysts
• Asset based valuation
• Tobins q
• Firm value Replacement cost of assets Value
  of growth options

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Key Concepts and Points

• Valuation using other multiples
• Analysts use other multiples appropriate for
  specific industries
  
• Some sector specific or for want of data on
  earnings and cashflows
  
• Price/sales, revenue per customer in service
  industry, revenue per hotel room
  
• Relation to value drivers like profits, cash
  flows and dividends far fetched
  
• Discounted cash flow model (DCF)

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Key Concepts and Points

• Free cash flow to equity holders (FCFE)
  discounted at cost of equity
  
• Free cash flow to firm (FCFF) discounted at WACC
• Steps in DCF model
• 1. Estimate the future cash flows of the target
  based on the assumptions for its post-acquisition
  management by the bidder over the forecast
  horizon.
• 2. Estimate the terminal value of the target at
  forecast horizon.
  

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Key Concepts and Points

• 3. Estimate the cost of capital appropriate for
  the target, given its projected post-acquisition
  risk and capital structure.
  
• 4. Discount the estimated cash flows to give a
  value of the target.
  
• 5. Add other cash inflows from sources such as
  asset disposals or business divestments.
  

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Key Concepts and Points

• 6. Subtract debt and other expenses, such as tax
  on gains from disposals and divestments, and
  acquisition costs, to give a value for the equity
  of the target.
• 7. Compare the estimated equity value for the
  target with its pre-acquisition stand-alone value
  to determine the added value from the
  acquisition.
• 8. Decide how much of this added value should be
  given away to target shareholders as control
  premium.

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Key Concepts and Points

• Value drivers
• Key revenue, cost or investment variables which
  determine cash flows, and value to shareholders.
  
• Forecast sales growth in volume and revenue
  terms.
  
• Operating profit margin.
• New fixed capital investment.
• New working capital investment.
• The cost of capital.
• Period over which acquirer can maintain
  competitive advantage.
  
• Estimating WACC

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Key Concepts and Points

• WACC KeE/V (1 Tc) Kd D/V Kp P/V
• Equity cost of capital,
• Market premium Expected return on the market,
  RM Risk-free rate, RF
  
• Beta

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Key Concepts and Points

• The purchase price
• Value of target to bidder
• .
• Example of DCF valuation of a target
• Terminal value
• Sensitivity analysis

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Key Concepts and Points

• Value of private companies
• Impact of tax on target valuation
• Can past losses be carried forward to reduce
  future tax liability?
  
• Real options model for valuing targets
• Many corporate investments like acquisitions are
  contingent
  
• Their value depending on future growth
  opportunities and future investment

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Key Concepts and Points

• Firms have option to make future investments or
  abandon investments already made
  
• Example of real options R D, advertising,
  investing in first generation technology with
  potential for future generations
  
• Real option framework modelled on call and put
  options on financial assets like shares and
  bonds
  
• Black-Scholes Option Pricing Model (BSOPM)

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Key Concepts and Points

• C S N (d1) E ert N(d2)
• Where d1 ln(S/E) (r _?(2)t /? ?2t and
• d2 d1 ? ?2t S current stock price
• E exercise price r annual risk free
  continuously compounded rate ?2 annualised
  variance of the continuous return on the stock
  and t time to expiry of the option.
• Financial options and real options
• Growth, abandonment, switch and scaling-up
  options
  
• Valuation of real options using BSOPM
• C the first stage investment

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Key Concepts and Points

• S present value of the second stage investment
• t the time to making the second stage
  investment i.e. how long will that opportunity be
  open i.e. how can the second stage investment be
  deferred.
• X present value of the cost of the second stage
  investment
  
• Dividend intermediate costs to keep the second
  stage investment opportunityopen e.g. maintenance
  costs, rents etc
  
• ? the volatility of the value of the second
  stage investment
  

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Key Concepts and Points

• Risk free rate has same connotation as in
  financial option model
  
• Real options a learning opportunity about the
  outcome of initial investment and whether
  subsequent investments will create value
  
• Competitor reactions affect value of learning,
  future investments and waiting to exercise option
  on future multi-stage investments volatility of
  cash flows of future multi-stage investments
• Real options in practice difficult to apply
  because of need to understand volatility and how
  model parameters evolve over time
  

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Value Sources in Acquisitions
Note Value added by acquirer is net of
associated costs, e.g. redundancy, integration
assuming acquirer market capitalization of 500m,
gain to acquirer shareholders is just 1.
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Income Statement of Target Plc (m)
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Balance Sheet of Target Plc (m)
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Pro Forma Income Statement of Target under Bidder
(m)
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Value of Target to Bidder (m)
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Valuation of Target Equity Using Forecast Free
Cash Flows (m)
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Sensitivity of Target Value to Value Drivers
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Types of Real Options Where Do They Exist?
Source L. Trigeorgis, Real Options, Managerial
Flexibility and Strategy in Resource Allocation
(Cambridge, MA MIT Press, 1996), Table 1.1
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Comparing Financial and Real Options