©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston Chapter Alternative Approaches to Valuation

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 2 Introduction Valuation critical in M&As Framework essential to discipline valuation estimates

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 4 Average ratios applied to absolute data for company of interest Indicated market values obtained from each ratio Valuation judgments are made

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 5 Advantages –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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 8 –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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 14 Development of compact valuation formulas –Valuation necessarily requires forecasts –Usually assumes systematic relations between time periods, variables Key variables and relationships –Revenues (R t ) 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 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)

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 16 –Investment (I t ) 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 18 Sensitivity analysis –Purpose 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 22 Cost of equity –Capital Asset Pricing Model (CAPM) k s = R f + [R M - R f ]  j Risk-free rate (R f ) –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 (R M - R f ) –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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 23 –Dividend growth model Cost of equity based on the constant-growth dividend valuation model Required return on equity is expected dividend yield (D 1 /S 0 ) plus expected growth rate of dividends in perpetuity (g)

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 26 Cost of debt –Cost of debt calculated on an after-tax basis because interest payments are tax deductible After-tax cost of debt = k b (1 - T ) –Before-tax cost of debt, k b 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 27 Weighted cost of capital –Cost of capital, k, is weighted average of marginal cost of equity and debt k = k b (1-T)(B/V)+k s (S/V) where: k b =cost of debt k s =cost of equity T=tax rate B=value of debt S=value of equity V=total value of firm = B + S –or k = k u (1-TL) where: k u =cost of capital of an unlevered firm L=B/V

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 28 –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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 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

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 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