Valuation for Mergers & Acquisitions

Valuation for Mergers & Acquisitions
Prof. Ian Giddy New York University

What’s a Company Worth to Another Company?
Required Returns Types of Models Balance sheet models Dividend discount & corporate cash flow models Price/Earnings ratios Option models Estimating Growth Rates Application: How These Change with M&A Ipoh

Equity Valuation: From the Balance Sheet
Value of Assets Book Liquidation Replacement Value of Liabilities Book Market Value of Equity

Equity Valuation: From the Balance Sheet
Value of Assets Book Liquidation Replacement Value of Liabilities Book Market Value of Equity Book Value Liquidation Value Replacement Value Tobin’s Q: Market/Replacement tends to 1?

Relative Valuation Do valuation ratios make sense?
• Price/Earnings (P/E) ratios and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples) • Price/Book (P/BV) ratios and variants (Tobin's Q) • Price/Sales ratios It depends on how they are used -- and what’s behind them! This is the preferred mode of valuation on Wall Street. Philosophically, it is a different way of thinking about valuation. In relative valuation, we assume that markets make mistakes on individual investments, but that they are right, on average, in how they price a sector or the market. (In discounted cash flow valuation, we assume that markets make mistakes over time.)

Discounted Cashflow Valuation: Basis for Approach
where n = Life of the asset CFt = Cashflow in period t r = Discount rate reflecting the riskiness of the estimated cashflows The basics of valuation are no different from the basics of project analysis. The value of any asset is the present value of the expected cash flows over its life.

Valuing a Firm with DCF: An Illustration
Historical financial results Adjust for nonrecurring aspects Gauge future growth Projected sales and operating profits Adjust for noncash items Projected free cash flows to the firm (FCFF) Year 1 FCFF Year 2 FCFF Year 3 FCFF Year 4 FCFF Terminal year FCFF … Stable growth model or P/E comparable Discount to present using weighted average cost of capital (WACC) Present value of free cash flows + cash, securities & excess assets - Market value of debt Value of shareholders equity

Estimating Future Cash Flows
Dividends? Free cash flows to equity? Free cash flows to firm?

Value Shareholders’ Equity?
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 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. The value of equity is the present value of cash flows to the equity investors discounted back at the rate of return that those equity investors need to make to break even (the cost of equity). In the strictest sense of the word, the only cash flow stockholders in a publicly traded firm get from their investment is dividends, and the dividend discount model is the simplest and most direct version of an equity valuation model.

Or Value the Whole Firm? 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 Firmt = Expected Cashflow to Firm in period t WACC = Weighted Average Cost of Capital One way to think about the value of the firm is in terms of the different claimholders in the firm. The cash flow to the firm is the cumulated cash flows obtained by all claimholders in the firm (Equity investors get dividends, debt holders get interest and principal payments and preferred stockholders get preferred dividends). The appropriate discount rate for these cash flows has to be the weighted average of all of their required rates of return, which is the cost of capital.

Equity Valuation versus Firm Valuation
Value just the equity stake in the business Value the entire firm, which includes, besides equity, the other claimholders in the firm In the context of M&A or financial restructuring, we want to know the value of the firm because we’ll probably change the debt structure. In equity valuation, we look at the entire analysis from the perspective of equity investors in the firms. (This is analogous to an equity approach in investment analysis) In firm valuation, we try to value the underlying business, with all the different claims on it (debt, equity and preferred stock)

The Weighted Average Cost of Capital
Choice Cost 1. Equity Cost 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. Debt Cost 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 Capital cost of debt; weights based upon market value. Cost of capital = kd [D/(D+E)] + ke [E/(D+E)] This provides a summary of the two basic approaches to raising capital - debt and equity. Every other approach is some hybrid of these two.

Valuation: The Key Inputs
A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever. 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: In practical terms, this means that we have to estimate detailed cash flows until we expect the firm to be in stable growth. The alternative way of applying closure, which is to estimate the terminal value by applying a multiple of earnings to the fifth or tenth year’s earnings ends up being a relative valuation rather than a discounted cash flow valuation. (The value is heavily influenced by the multiple used to get terminal value)

Dividend Discount Models: General Model
V0 = Value of Stock Dt = Dividend k = required return

Specified Holding Period Model
PN = the expected sales price for the stock at time N N = the specified number of years the stock is expected to be held

No Growth Model Stocks that have earnings and dividends that are expected to remain constant Preferred Stock

No Growth Model: Example
Burlington Power & Light has earnings of $5 per share and pays out 100% dividend The required return that shareholders expect is 15% The earnings are not expected to grow but remain steady indefinitely What’s a BPL share worth? E1 = D1 = $5.00 k = .15 V0 = $5.00 / .15 = $33.33

g = constant perpetual growth rate
Constant Growth Model g = constant perpetual growth rate

Constant Growth Model: Example
Motel 6 has earnings of $5 per share. It reinvests 40% and pays out 60%dividend The required return that shareholders expect is 15% The earnings are expected to grow at 8% per annum What’s an M6 share worth? E1 = $5.00 b = 40% k = 15% (1-b) = 60% D1 = $3.00 g = 8% V0 = 3.00 / ( ) = $42.86 Plowback rate

Estimating Dividend Growth Rates
g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate i.e.(1- dividend payout percentage rate)

Shifting Growth Rate Model
g1 = first growth rate g2 = second growth rate T = number of periods of growth at g1

Shifting Growth Rate Model: Example
Mindspring pays dividends $2 per share. The required return that shareholders expect is 15% The dividends are expected to grow at 20% for 3 years and 5% thereafter What’s a Mindspring share worth? D0 = $ g1 = 20% g2 = 5% k = 15% T = 3 D1 = 2.40 D2 = D3 = D4 = 3.63 V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3 + D4 / ( ) ( (1.15)3 V0 = = $30.40

Stable Growth and Terminal Value
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 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. While companies can maintain high growth rates for extended periods, they will all approach “stable growth” at some point in time. When they do approach stable growth, the valuation formula above can be used to estimate the “terminal value” of all cash flows beyond. To apply the terminal value approach, the firm has to be in a growth rate that is sustainable forever. Since no firm can grow faster than the economy in which it operates forever, this puts the logical bound of the economy’s growth rate on this number. If this is done in real terms, it will be the economy’s real growth rate To the extent that a firm (like Coca Cola) services the world economy the real growth rate of the world economy can be used. The nominal growth rate that can be used will depend upon the currency in which the cash flows are estimated. The expected inflation rate in that currency can be added to the real growth rate to arrive at the nominal growth rate. As a simple rule of thumb, this nominal growth rate should not be much higher than the long term government bond rate.

Growth Patterns 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) 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) There is a strong subjective element to this process, since we are looking at estimates for the future. Everything you know about the firm, the sector in which it operates and the overall economy will go into making this judgment. Microsoft, for instance, is a very large firm, but the barriers to entry it has created may allow it to maintain high growth for a long period.

Length of High Growth Period
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 Biogen, because it has greater barriers to entry can be expected to have a logner growth period. Earthlink might be well managed, but the excess returns will draw competitors into the business, which, in turn, will reduce the potential for high growth in the future.

Choosing a Growth Pattern: Examples
Company Valuation in Growth Period Stable Growth Disney Nominal U.S. $ 10 years 5%(long term Firm (3-stage) nominal growth rate in the U.S. economy Aracruz Real BR 5 years 5%: based upon Equity: FCFE (2-stage) expected long term real growth rate for Brazilian economy Deutsche Bank Nominal DM 0 years 5%: set equal to Equity: Dividends nominal growth rate in the world economy I would not be inclined to use growth periods longer than 10 years. While there are firms like IBM, Microsoft and Coca Cola which have been able to sustain growth for much longer periods, they are more the exception than the rule. Most firms are able to maintain high growth for shorter periods. I am going to use firm valuation for Disney, because I expect leverage to change, and firm valuation is simpler when that occurs For Aracruz, I will use FCFE, since I do not expect leverage to change, and do the analysis in real terms, to avoid having to deal with expected inflation in BR For Deutsche Bank, where it is difficult to estimate free cash flows, I will use dividends and make the assumptions that dividends over time will be equal to FCFE.

The Building Blocks of Valuation
Valuation models represent some combination of these three choices - a cash flow, a discount rate and a growth pattern.

Relative Valuation 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 and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples) • Price/Book (P/BV) ratios and variants (Tobin's Q) • Price/Sales ratios This is the preferred mode of valuation on Wall Street. Philosophically, it is a different way of thinking about valuation. In relative valuation, we assume that markets make mistakes on individual investments, but that they are right, on average, in how they price a sector or the market. (In discounted cash flow valuation, we assume that markets make mistakes over time.)

P/E Ratios are a function of two factors
Price Earnings Ratios P/E Ratios are a function of two factors Required rates of return (k) Expected growth in dividends Uses Relative valuation Extensive use in industry

Ratios Do Have Meaning Gordon Growth Model:
Dividing both sides by the earnings, Dividing both sides by the book value of equity, If the return on equity is written in terms of the retention ratio and the expected growth rate Dividing by the Sales per share, All multiples have their roots in fundamentals. A little algebra can take a discounted cash flow model and state it in terms of a multiple. This, in turn, allows us to find the fundamentals that drive each multiple: PE : Growth, Risk, Payout PBV: Growth, Risk, Payout, ROE PS: Growth, Risk, Payout, Net Margin. Every multiple has a companion variable, which more than any other variable drives that multiple. The companion variable for the multiples listed above are underlined. When comparing firms, this is the variable that you have to take the most care to control for. When people use multiples because they do not want to make the assumptions that DCF valuation entails, they are making the same assumptions implicitly.

P/E Ratio: No expected growth
E1 - expected earnings for next year E1 is equal to D1 under no growth k - required rate of return

P/E Ratio with Constant Growth
Where b = retention ratio ROE = Return on Equity

Numerical Example: No Growth
E0 = $ g = 0 k = 12.5% P0 = D/k = $2.50/.125 = $20.00 P/E = 1/k = 1/.125 = 8 Quickie Broom Co has earnings of $2.50 per share. It pays out 100%dividend The required return that shareholders expect is 12.5% (based on CAPM with Beta of 1, RF = 7%, Market risk premium 5.5%) What PE ratio should such a company have?

Numerical Example with Growth
b = 60% ROE = 15% (1-b) = 40% E1 = $2.50 (1 + (.6)(.15)) = $2.73 D1 = $2.73 (1-.6) = $1.09 k = 12.5% g = 9% P0 = 1.09/( ) = $31.14 PE = 31.14/2.73 = 11.4 PE = ( ) / ( ) = 11.4

Disney: Relative Valuation
PE ratio divided by the growth rate Disney: Relative Valuation Company PE Expected Growth PEG King World Productions % 1.49 Aztar % 0.99 Viacom % 0.67 All American Communications % 0.79 GC Companies % 1.35 Circus Circus Enterprises % 1.22 Polygram NV ADR % 1.74 Regal Cinemas % 1.12 Walt Disney % 1.55 AMC Entertainment % 1.48 Premier Parks % 1.18 Family Golf Centers % 0.92 CINAR Films % 1.94 Average % 1.20 Note that when people compare firms across sectors, they implicitly assume that firms in a sector have similar risk and cash flow characteristics. This is clearly a dangerous assumption to make. The PEG ratio is a simplistic way of controlling for expected growth differences across firms. A low PEG ratio is viewed as a sign of an undervalued firm. The PEG ratio is based upon the implicit assumption that PE and expected growth are linearly related.

Is Disney fairly valued?
Based upon the PE ratio, is Disney under, over or correctly valued? Under Valued Over Valued Correctly Valued Based upon the PEG ratio, is Disney under valued? Will this valuation give you a higher or lower valuation than the discounted CF valuation? Higher Lower If we assume that all of the firms in this sector have similar growth, risk and payout characteristics, Disney is correctly valued, because its PE is close to the industry average. On a PEG ratio basis, if we assume that all firms in this sector have similar risk and payout characteristics, Disney is overvalued. It is tough to say. It depends upon whether the DCF valuation is making reasonable assumptions and whether the market, on average, is pricing these firms correctly.

Relative Valuation Assumptions
Assume that you are reading an equity research report where a buy recommendation for Viacom 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 All of the above.

Equity Valuation: Application to M&A
Prof. Ian Giddy New York University

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)

Application 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. What is the maximum price that Fakawi should offer for Feng-Shui?

The Gains From an Acquisition
Gains from merger Synergies Control Top line Bottom line Financial restructuring Business Restructuring (M&A)

Framework for Assessing Retructuring Opportunities
Current Market Value Current market overpricing or underpricng Maximum restructuring opportunity 1 Total restructured value Company’s DCF value 2 5 Restructuring Framework Financial structure improvements Operating improvements (Eg Increase D/E) 3 4 Potential value with internal + external improvements Potential value with internal improvements Disposal/ Acquisition opportunities

Equity Valuation in Practice
Estimating discount rate Estimating cash flows Application to Optika Application in M&A: Schirnding-Optika

Optika WACC: ReE/(D+E)+RdD/(D+E) Value: FCFF/(WACC-growth rate) CAPM:
7%+1(5.50%) Equity Value: Firm Value - Debt Value = = 2028 Debt cost (7%+1.5%)(1-.35)

Optika & Schirnding

Optika-Schirnding with Synergy

Optika-Schirnding with Synergy
Case Study: Ipoh-Kelantan

Ipoh-Kelantan

Appendix Corporate Cash Flow Valuation:

Valuing a Firm – The Basics
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.

Corporate Cash Flow Valuation: Special Situations
When investors’ actual or perceived risks are higher – may have to add risk premiums to required returns When the company is private – may have to guess risk factors, value of shares, etc When the company’s earnings have been negative or unusually low – may have to normalize When the company’s future is highly speculative – may have to use an options approach to valuation

Corporate Cash Flow Valuation: The Steps
Estimate the discount rate or rates to use in the valuation Discount rate can be either a cost of equity (if doing equity valuation) or a cost of capital (if valuing the firm) Discount rate can be in nominal terms or real terms, depending upon whether the cash flows are nominal or real Discount rate can vary across time. Estimate the current earnings and cash flows on the asset, to either equity investors (Free CF to Equity) or to all claimholders (Free CF to Firm) Estimate the future earnings and cash flows on the asset being valued, generally by estimating an expected growth rate in earnings. Estimate when the firm will reach “stable growth” and what characteristics (risk & cash flow) it will have when it does. Choose the right DCF model for this asset and value it.

Estimating Cash Flows to Firm
EBIT ( 1 - tax rate) - (Capital Expenditure - Depreciation) - Change in Non-Cash Working Capital = Cash flow to the firm Alternatively, - Reinvestment Needs

What is the EBIT of a firm?
The EBIT, measured right, should capture the true operating income from assets in place at the firm. Any expense that is not an operating expense or income that is not an operating income should not be used to compute EBIT. In other words, any financial expense (like interest expenses) or capital expenditure should not affect your operating income. Can you name A financing expense that gets treated as an operating expense? A capital expense that gets treated as an operating expense?

Operating Lease Expenses: Operating or Financing Expenses
Operating Lease Expenses are treated as operating expenses in computing operating income. In reality, operating lease expenses should be treated as financing expenses, with the following adjustments to earnings and capital: Debt Value of Operating Leases = PV of Operating Lease Expenses at the pre-tax cost of debt Adjusted Operating Earnings = Operating Earnings + Pre-tax cost of Debt * PV of Operating Leases.

R&D Expenses: Operating or Capital Expenses
Accounting standards require us to consider R&D as an operating expense even though it is designed to generate future growth. It is more logical to treat it as capital expenditures. To capitalize R&D, Specify an amortizable life for R&D ( years) Collect past R&D expenses for as long as the amortizable life Sum up the unamortized R&D over the period. (Thus, if the amortizable life is 5 years, the research asset can be obtained by adding up 1/5th of the R&D expense from five years ago, 2/5th of the R&D expense from four years ago...:

Capitalizing R&D Expenses: Bristol Myers
R & D was assumed to have a 10-year life. Year R&D Expense Unamortized portion $ Value Value of research asset = $ 6,371 million Amortization of research asset in 1998 = $ 637 million Adjustment to Operating Income = $ 1,385 million - $ 637 million =$ 748 million

What tax rate? The tax rate that you should use in computing the after-tax operating income should be The effective tax rate in the financial statements (taxes paid/Taxable income) The tax rate based upon taxes paid and EBIT (taxes paid/EBIT) The marginal tax rate None of the above Any of the above, as long as you compute your after-tax cost of debt using the same tax rate

The Right Tax Rate to Use
The choice really is between the effective and the marginal tax rate. In doing projections, it is far safer to use the marginal tax rate since the effective tax rate is really a reflection of the difference between the accounting and the tax books. By using the marginal tax rate, we tend to understate the after-tax operating income in the earlier years, but the after-tax tax operating income is more accurate in later years If you choose to use the effective tax rate, adjust the tax rate towards the marginal tax rate over time. The tax rate used to compute the after-tax cost of debt has to be the same tax rate that you use to compute the after-tax operating income.

A Tax Rate for a Money Losing Firm
Assume that you are trying to estimate the after-tax operating income for a firm with $ 1 billion in net operating losses carried forward. This firm is expected to have operating income of $ 500 million each year for the next 3 years, and the marginal tax rate on income for all firms that make money is 40%. Estimate the after-tax operating income each year for the next 3 years. Year 1 Year 2 Year 3 EBIT Taxes EBIT (1-t) Tax rate

Normalizing Earnings In most valuations, we begin with the current operating income and estimate expected growth. This practice works as long as Current operating income is positive Current operating income is normal. (In any given year, the operating income can be too low, if the firm has had a poor year, or too high, if it has had an explosively good year) If the current operating income is negative, it has to be normalized. How you normalize earnings will depend upon why the earnings are negative in the first place.

Net Capital Expenditures
Net capital expenditures represent the difference between capital expenditures and depreciation. Depreciation is a cash inflow that pays for some or a lot (or sometimes all of) the capital expenditures. In general, the net capital expenditures will be a function of how fast a firm is growing or expecting to grow. High growth firms will have much higher net capital expenditures than low growth firms. Assumptions about net capital expenditures can therefore never be made independently of assumptions about growth in the future.

Working Capital Investments
In accounting terms, the working capital is the difference between current assets (inventory, cash and accounts receivable) and current liabilities (accounts payables, short term debt and debt due within the next year) A cleaner definition of working capital from a cash flow perspective is the difference between non-cash current assets (inventory and accounts receivable) and non-debt current liabilities (accounts payable) Any investment in this measure of working capital ties up cash. Therefore, any increases (decreases) in working capital will reduce (increase) cash flows in that period. When forecasting future growth, it is important to forecast the effects of such growth on working capital needs, and building these effects into the cash flows.

Estimating FCFF: Siderar
EBIT (1998) = 161 million Tax rate used = 33.45% (Assumed Effective = Marginal) Capital spending (1998) = 118 million Depreciation (1998) = 70 million Non-cash Working capital Change (1998) = 25 million (Normalized to make working capital 24.79% of revenues) Estimating FCFF (1998) Current EBIT * (1 - tax rate) = 161 ( ) = 107 million - (Capital Spending - Depreciation) = = 48 million - Change in Working Capital = 25 million Current FCFF = 34 million

Estimating Growth When valuing firms, some people use analyst projections of earnings growth (over the next 5 years) that are widely available in Zacks, I/B/E/S or First Call in the US, and less so overseas. This practice is Fine. Equity research analysts follow these stocks closely and should be pretty good at estimating growth Shoddy. Analysts are not that good at projecting growth in earnings in the long term. Wrong. Analysts do not project growth in operating earnings

Expected Growth in EBIT and Fundamentals
Reinvestment Rate and Return on Capital gEBIT = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC = Reinvestment Rate * ROC Proposition 2: No firm can expect its operating income to grow over time without reinvesting some of the operating income in net capital expenditures and/or working capital. Proposition 3: The net capital expenditure needs of a firm, for a given growth rate, should be inversely proportional to the quality of its investments.

Expected Growth and Siderar
Return on Capital = EBIT (1- tax rate) / (BV of Debt + BV of Equity) = 107 /(68+597) = 16.13% Reinvestment Rate = (Cap Ex - Deprcn + Chg in WC)/EBIT (1-t) = ( )/ 107= 67.66% Expected Growth in Operating Income = (.6766) (16.13%) = 10.91%

Growth Patterns 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) Stable Growth 2-Stage Growth 3-Stage Growth

Determinants of Growth Patterns
Size of the firm Success usually makes a firm larger. As firms become larger, it becomes much more difficult for them to maintain high growth rates Current growth rate While past growth is not always a reliable indicator of future growth, there is a correlation between current growth and future growth. Thus, a firm growing at 30% currently probably has higher growth and a longer expected growth period than one growing 10% a year now. Barriers to entry and differential advantages Ultimately, high growth comes from high project returns, which, in turn, comes from barriers to entry and differential advantages. The question of how long growth will last and how high it will be can therefore be framed as a question about what the barriers to entry are, how long they will stay up and how strong they will remain.

Dealing with Cash and Other Non-operating Assets
The simplest and most direct way of dealing with cash and marketable securities is to keep it out of the valuation - the cash flows should be before interest income from cash and securities, and the discount rate should not be contaminated by the inclusion of cash. (Use betas of the operating assets alone to estimate the cost of equity). Once the firm has been valued, add back the value of cash and marketable securities. If you have a particularly incompetent management, with a history of overpaying on acquisitions, markets may discount the value of this cash. The more difficult assets to value are minority holdings in subsidiaries. The right way to value these holdings is to value the subsidiaries themselves, and take the firm’s ownership portion of this value. Unfortunately, accounting standards do not allow for much transparency, especially when the subsidiaries are not publicly traded.

The Choices in DCF Valuation

Appendix Key Financial Ratios
Short-Term Solvency or Liquidity Ability to pay bills in the short-run Long-Term Solvency/Leverage Ability to meet long-term obligations Asset Management Intensity and efficiency of asset use Profitability Market Value Going beyond financial statements

Profitability Ratios Net Profit Margin % Net Income Sales Return on Assets Total Assets

Profitability Ratios Return on Equity Net Income Common Equity Operating Margin After Depr. Operating Profit Sales

Decomposition of ROE (1) x (2) x (3) x (4) x (5) ROE = Net Profit
Pretax Profit Pretax Profit EBIT EBIT Sales Sales Assets Assets Equity ROE = x x x x (1) x (2) x (3) x (4) x (5) Tax Burden Interest Burden x x Margin x Turnover x Leverage

Financial Ratios Are Useful
What aspect of the firm or its operations are we attempting to analyze? Firm performance can be measured along “dimensions” What goes into a particular ratio? Historical cost? Market values? Accounting conventions? What is the unit of measurement? Dollars? Days? Turns? What would a desirable ratio value be? What is the benchmark? Time-series analysis? Cross-sectional analysis?

Appendix Valuation Using the Options Approach
Value of the Firm or project Present Value of Expected Cash Flows if Option Excercised

Project Options One of the limitations of traditional investment analysis is that it is static and does not do a good job of capturing the options embedded in investment. The first of these options is the option to delay taking a project, when a firm has exclusive rights to it, until a later date. The second of these options is taking one project may allow us to take advantage of other opportunities (projects) in the future The last option that is embedded in projects is the option to abandon a project, if the cash flows do not measure up. These options all add value to projects and may make a “bad” project (from traditional analysis) into a good one.

The Option to Delay When a firm has exclusive rights to a project or product for a specific period, it can delay taking this project or product until a later date. A traditional investment analysis just answers the question of whether the project is a “good” one if taken today. Thus, the fact that a project does not pass muster today (because its NPV is negative, or its IRR is less than its hurdle rate) does not mean that the rights to this project are not valuable.

Valuing the Option to Delay a Project
PV of Cash Flows from Project Initial Investment in Project Present Value of Expected Cash Flows on Product Project's NPV turns Project has negative positive in this section NPV in this section

The Option to Expand/Take Other Projects
Taking a project today may allow a firm to consider and take other valuable projects in the future. Thus, even though a project may have a negative NPV, it may be a project worth taking if the option it provides the firm (to take other projects in the future) provides a more-than-compensating value. These are the options that firms often call “strategic options” and use as a rationale for taking on “negative NPV” or even “negative return” projects.

The Option to Expand PV of Cash Flows from Expansion
Additional Investment to Expand Present Value of Expected Cash Flows on Expansion Expansion becomes Firm will not expand in attractive in this section this section

An Example of a Corporate Option
J&J is considering investing $110 million to purchase an internet distribution company to serve the growing on-line market. A conventional NPV financial analysis of the cash flows from this investment suggests that the present value of the cash flows from this investment to J&J will be only $95 million. Thus, by itself, the corporate venture has a negative NPV of $15 million. If the on-line market turns out to be more lucrative than currently anticipated, J&J could expand its reach a global on-line market with an additional investment of $125 million any time over the next 2 years. While the current expectation is that the PV of cash flows from having a worldwide on-line distribution channel is only $100 million (still negative NPV), there is considerable uncertainty about both the potential for such an channel and the shape of the market itself, leading to significant variance in this estimate. This uncertainty is what makes the corporate venture valuable!

Valuing the Corporate Venture Option
The corporate option would cost an expected $15 million. But what is it worth to J&J? Value of the underlying asset (S) = PV of cash flows from purchase of on-line selling venture, if done now =$100 Million Strike Price (K) = cost of expansion into global on-line selling = $125 Million We estimate the variance in the estimate of the project value by using the annualized volatility (standard deviation) in firm value of publicly traded on-line marketing firms in the global markets, which is approximately 50%. Variance in Underlying Asset’s Value = SD^2=.25 Time to expiration = Period for which “venture option” applies = 2 years 2-year interest rate: 6.5%

Black-Scholes Option Valuation
Call value = SoN(d1) - Xe-rTN(d2) d1 = [ln(So/X) + (r + 2/2)T] / (T1/2) d2 = d1 - (T1/2) where So = Current stock price X = Strike price, T = time, r = interest rate N(d) = probability that a random draw from a normal distribution will be less than d.

Valuing the Corporate Venture Option
Value of the underlying asset (S) = PV of cash flows from purchase of on-line selling venture, if done now =$100 Million Strike Price (X) = cost of expansion into global on-line selling = $125 Million We estimate the variance in the estimate of the project value by using the annualized standard deviation in firm value of publicly traded on-line marketing firms in the global markets, which is approximately 50%. Variance in Underlying Asset’s Value = SD^2=0.25 Time to expiration = Period for which “venture option” applies = 2 years 2-year interest rate: 6.5% Call Value = 100 N(d1) -125 (exp(-0.065)(2)) N(d2) = $ 24.2 Million This values the option, using the Black Scholes model. The value from the model itself is affected not only by the assumptions made about volatility and value, but also by the asssumptions underlying the model. The value itself is not the key output from the model. It is the fact that strategic options, such as this one, can be valued, and that they can make a significant difference to your decision.

Conclusion? Johnson & Johnson should go ahead and invest in the venture -- the value of the option ($24 million) exceeds the cost ($15 million) Can this approach be used to value highly speculative ventures?

www.giddy.org Ian Giddy NYU Stern School of Business
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Valuation for Mergers & Acquisitions

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Valuation for Mergers & Acquisitions

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