j.v. rizzi august, 2007. strategic issues do i make the acquisition? valuation how much do i pay?...
TRANSCRIPT
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J.V. RizziAugust, 2007
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Strategic Issues • Do I make the acquisition?
Valuation • How much do I pay?
Financing • How do I pay?
Integration • Implementation of acquisition
Tactics • How do I make the offer?
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Market • What is the price?
Market Conditions • Product availability
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• Conversion• Accrual to Cash• Cost to Market
• Starting Point• Private Firm: Asset Valuation (LHS)• Public Firm: Liabilities (RHS)• Note: Private/Public Market arbitrage
• Value Gaps• Expectation• Strategic
• Price ≠ Value• Note: Both price and value are dynamic concepts
• Firms Compete in Two Markets• Product Markets: For Customers• Financial Markets: For Capital
• Passive Trading Price• Control Price
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• Other• Distress• Employees• Other (community, retirees, etc.)
• Ordinarily, value is independent of claims issued• Claims can impact value through their incentive on management behavior
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Assets (LHS)
Assets in Place
Growth
Opportunities
Claims (RHS)
Other
DebtEquity
Taxes (Govt)
=
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• A bird in the hand is worth ….two in the bush
◦ How certain are you that there are birds in the bush?◦ When will they emerge and how many will there be?◦ What is the risk-free interest rate (i.e. the yield on long
term sovereign bonds)?
Answer these three questions and …you will know the maximum value of the
bush!
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• When new businesses and rapidly changing industries are under examination, no one can anticipate the number of birds about to emerge.
◦ In these cases, any investment would be considered speculative
◦ - Speculation - the focus is not on what the asset will produce, but rather on what the next fellow will pay for it…
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Valuation Overview
V = MAX (liquidation, Going Concern, Third Party Sale)
method used depends on point of life cycle and market conditions – value of asset with no cash flow is only what someone will pay you for it (Sardine theorem)
TPS – Startup GC – Mature Liq - Decline
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Market Size
Emerging High Growth Mature Market Stage
Independent Value
BuyerDrivenValue
Timing
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Enterprise (or controlling interest value)
Premium for Control
Marketable minority-interest value(Wall Street Journal Listed Price)
Non-marketable minority-interest value
Controlling shareholders (those who own more than 50% in most cases) have the powerto declare dividends, sell assets, Change corporate bylaws , and more
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• Free Cash Flow (WACC) – Focus of our discussion• Best known method• Best used for stable capital structure
• Adjust to fit rapidly changing capital structure by using an assumed target capital structure (BBB+/A-)
• Capital Cash Flow (APV)• Less well known• Best for rapidly changing capital structures
• Equity Cash Flows• Best used with complex equity flows• Used by financial sponsors
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Plus DepreciationLess Capital Expenditures
Less Working Capital Increases
Equity Cash Flow
Subtract Actual TaxesTax Rate + (EBIT – Interest)
Operating Cash Flow
Discount at Expected Asset Return
Capital Cash Flow
Subtract Actual TaxesTax Rate + (EBIT – Interest)
Free Cash Flow
Earning Before Interest and TaxesEBIT
Discount at Expected Equity Return
Less InterestLess Debt PaymentsPlus Debt Issuance
Subtract Hypothetical TaxesStatutory Tax Rate x EBIT
Discount at WACC
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• A Discounted Cash Flow method that applies a discount rate to the projected free cash flows generated by the firm. There are three primary inputs in the DCF analysis:
◦ Project Cash Flows are prepared using management’s best estimate of company and industry factors (seasonality, cyclicality, etc.) or implied from the current stock price. Should reflect the period of abnormal growth based on competitive considerations.
◦ Terminal value is the portion of the firm value after the forecast horizon. It can often represent a significant percentage of the total firm value. Represents the value of assets in place.
◦ Discount rate
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• Forecast Free Cash Flow◦ Identify components of free cash flow◦ Develop integrated historical perspective◦ Determine forecast assumptions and scenarios◦ Calculate and evaluate the forecast
• Estimating the cost of capital◦ Develop target market value debt and equity weights◦ Estimate cost of debt◦ Estimate cost of equity
• Estimate Continuing (Terminal) Value◦ Determine the relationship between continuing value and DCF◦ Decide the forecast horizon◦ Discount to the present
• Calculating and interpreting results◦ Develop and test results◦ Interpret results within decision context
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• Free Cash Flow◦ EBITDA – (Taxes + CAPEX +/- Working Capital)◦ An example is shown below:
2005 2006 2007 2008 2009
EBIT 324 350 378 408 441
DEPRECIATION EXPENSE 12 15 18 21 24
AMORTIZATION EXPENSE 5 5 5 5 5
EBITDA 341 370 401 434 470
CAPITAL EXPENDITURES (10) (12) (14) (16) (18)
INCREMENTAL WORKING
CAPITAL(10) (10) (11) (12) (13)
CASH TAXES (65) (70) (76) (82) (88)
FREE CASH FLOW 256 278 300 325 351
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Fin 70410 M&A Fall 2007Source: PLI
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• Issues◦ Adjustments (beware of solving for cash flows to
justify price)◦ Normalization
• Value Test
• Reverse Engineer◦ Firm◦ Peers
• Tie Into◦ Compensation◦ Covenants
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• Terminal Value◦ Terminal Value is the value of the cash flows after the forecast period.◦ The formula for calculating the terminal value is given below:
◦ After finding the terminal value, it must also be discounted at the same rate as the other cash flows.
◦ Beware of using EBITDA multiples – overstates due to take-over premiums
◦ On average, the Terminal Value accounts for over 80% of the total value.
◦ The credibility of management’s projections can be tested by remembering that the terminal value calculation is nothing more than applying a multiple to the final years cash flow (the implied multiple based on the WACC and growth rate = 1/[WACC-g]).
Terminal Value = FCFn * (1+g)
(WACC – g)
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:
WACC = Wd * Kd + We * Ke
Weighting
Total Debt
Total Equity
Total
Capitalization
USD %
1,254 75%
742 25%
1,996
After Tax Costs of Debt (use current
rates)
= (Risk Free Rate + Spread) ( 1-Tax Rate)
= (Rf + Rs) ( 1-T)
Cost of Equity (Rule of Thumb: 2*Rf)
= Risk Free + Beta (Equity Premium)
= Rf + B (Rm – Rf)
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Discounted Cash Flow Analysis (DCF) - OverviewDiscounted Cash Flow Analysis (DCF) - Overview
Advantages
• Theoretically, it is the most academically compelling valuation method.
• It is forward-looking and incorporates an expected operating strategy.
• Capital markets volatility has limited impact on the analysis.
• Recognizes the time value of money.
• Useful when there are not many comparable companies.
Disadvantages
• Highly sensitive to assumptions used (WACC, long term growth rate, terminal value, etc.).
• Forecasted future cash flows are uncertain.
• Terminal value can have a significant impact on valuation.
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• ABV is a cost based liquidation approach with mark to market adjustments◦ Balance sheets measure money spent, not value◦ Economic balance sheet needed (i.e. mark to market)
• Concept is to adjust for hidden assets and liabilities
• Potential Pitfall: Current Cost =/= Net Realizable Value
Hidden Assets Hidden Liabilities
• LIFO Reserve • Operating Leases
• PPE Appreciation • Underfunded Pension Plans
• Investment Appreciation • Underfunded Medical Benefit
• Overfunded Pension Plans • Guaranteed debt of others
• Net Operating Losses (NOL) • Contingencies (EPA, legal)
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Negative Synergies: Management as an off-balance sheet liability; conglomerate discount
Analysis: Earnings PEX Value
BU1BU2BU3BU4BU5
SOTPCurrent standalone value x
Gap
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• Multiples measure firm value by comparing it to other similar entities or transactions. The most common multiples are:
Comparable Public Trading Multiples
•Enterprise Value/EBITDA
Premiums:
- Liquidity
- Control
• Price/Earnings Ratio
•Price / Book Ratio
Comparable Transaction Multiples
• Deal Value / EBITDA Adjustments:
- Size
- Timing• Premium / Discounts
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• Why multiples are easy to calculate and used by many market analysts, there are some shortfalls:◦ The approach is inexact and can be skewed by outliers◦ Each firm is unique and it is therefore difficult to find
real comparables (companies or transactions)◦ Companies often manage around them
• Multiples are useful for:◦ Validation of DCF approach◦ Private company analysis◦ Segment valuation for multi-segment businesses
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Comparable Company Analysis (“Comps”) - OverviewComparable Company Analysis (“Comps”) - Overview
Advantages
• Provides an objective comparison of companies accounting for industry trends, risk factors and profitability expectations.
• Usually represented as forward looking, but also can be viewed as backward looking.
• Effective way of determining company valuation when no control premium is involved.
Disadvantages
• Putting together a list of truly comparable companies can often be difficult.
• Issues that are specific to a particular company may limit the strength of the valuation analysis.
• Does not account for control premiums or synergies gained in an acquisition.
• Analysis is focused on current market conditions, industry trends and growth prospects and ignores longer term issues.
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Precedent Transactions Analysis (“Precedents”) - OverviewPrecedent Transactions Analysis (“Precedents”) - Overview
Advantages
• Based on public information
•Information is based on historical information.
• Provides index of premiums paid by buyers and accepted by sellers.
• Important to know price that was paid for similar assets in determining present value of a comparable asset for sale.
Disadvantages
• Public data can be limited.
• Hard to know all the factors and motives that went into formulation of acquisitions prices.
• The fact that a particular multiple was paid in the past does not necessarily mean it still applies today.
• Market conditions at the time of a transaction can have a large impact on valuation.
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• International Valuation
• Real Option Valuation
• LBO Valuation
• Projection Credibility
• Restructuring Context
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• International Valuation creates a number of additional issues. There are two basic ways to handle international valuation: ◦ Value (and then present value) the cash flows in local currency
at local rates and then spot into the home currency.◦ Convert the local cash flows into the home currency and
discount those cash flows.
• Other issues to be aware of:◦ Cash flows depend on foreign inflation and exchange rate◦ The appropriate tax rate depends on the different tax laws in
the home and the foreign country◦ There are two relevant interest rates (foreign and domestic)◦ Political risk
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• DCF analysis was originally intended for passive investments where there is a direct cash flow to analyze (dividends).
• When valuing business acquisitions (or real assets), DCF fails to account for indirect cash flows. There are cash flows which arise due to the sequential interdependence between acquisitions / projects (i.e. an initial acquisition may have unattractive direct cash flows when viewed in isolation, but may be attractive when considering that it allows for a future opportunity to undertake another valuable investment / project.
• To overcome this shortfall, it is useful to think of a firm’s value in two parts. The first part is the DCF of the assets already in place, and the second is the value of the opportunity (or option) to invest in potentially valuable future projects.
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Merger Type Financial Strategic
Cash Flows Direct Indirect
Asset Base Existing Future
Technique DCF Option Pricing
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• The following table classifies the factors involved in determining a firm’s value under the real option valuation approach:
• By failing to use the real option value approach, the value of the strategic acquisitions involving indirect cash flows will be understated by a DCF analysis.
Analogy: valuing a convertible bond by only analyzing its coupon yield. Internet Firms: Today’s real options become tomorrow’s cash cows.
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• Usefulness depends on market conditions:◦ Financial Buyers◦ Strategic Buyers
• Approach: Maximize utilization of debt capacity
• Evaluate against expected ROI on required equity
Purchase Price = (D/EBITA)*EBITDA + (1-D/Cap)[Cap/D*(D/EBITDA)*EBITDA)]
max
Maximum Debt Required Equity
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Assets Liabilities &
Equity
Past Investment
Decisions
1. Operations
(Assets in Place)
Debt Claims
Future Investment
Decisions
2. Opportunities
(Real Options)
3. Equity Claims Securities Issues
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Problems Recommended
valution MethodLess
Formal
More
Formal
Operations
(Assets
in
Place)
Adjusted
Present
Value
Sales
Multiples
Book
Value
Multiples
EBIT
Multiples
Cash
Flow
Multiples
WACC
Based
DCF
Monte
Carlo
Simulation
Opportuni-
ties
(Real
Options)
Simple
Option
Pricing
Installed
Base
Multiples
Customer,
Subscriber
Multiples
Decisions
Trees
Simulation:
Scenario
Analysis
Fancy Option
Pricing
Equity
Claims
Equity
Cash
Flow
Net
Income
Multiples
P/E
Ratio’s
WACC-
based
DCF
minus Debt
Simulation:
Scenario
Analysis
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• Finding a valuation range:
◦ Use many estimators.◦ Exercise the estimators to get many estimates.◦ Scrutinize the assumptions and “key bets”.◦ Assess hidden options.◦ Consider unquantifiable factors.◦ Triangulate.
Source: Robert F. Bruner
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$0
$50
$100
$150
$200
$250
OptionOption
DCF
Peer P/E
Breakup
Transaction P/E
Mkt. Price
Source: Robert F. Bruner
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D C F E s t i m a t e s
V e n t u r e C a p i t a l / P r i v a t e
E q u i t y A p p r o a c h
M u l t i p l e s E s t i m a t e s• p e e r f i r m s• c o m p a r a b l e
t r a n s a c t i o n s R a n g e o f I n t r i n s i c
V a l u e
T r i a n g u l a t i o n a m o n g t h e e s t i m a t e s
C a s h F l o w s
eedd wkw)t1(iWACC
O p t i o n - b a s e d E s t i m a t e s
C u r r e n t M a r k e t V a l u e
B o o k V a l u e
L i q u i d a t i o n V a l u e
R e p l a c e m e n t V a l u e
F r e e C a s h F l o w a p p r o a c h
A d j u s t e d P r e s e n t V a l u e a p p r o a c h
R e s i d u a l C a s h F l o w a p p r o a c h
FMFe RRRk
E/D)t1(1uL
T e r m i n a l V a l u e s
gk
)g1(CFTV
C o s t o f C a p i t a l
Source: Robert F. Bruner
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Overview of Valuation Methodology
Summary of Valuation Methodology Valuation Method
Descrption
Comments
Comparable Company Trading Analysis
Provides Company’s implied vale in the public equity markets through analysis of comparable companies’ trading and operating statistics
Does not include control premium “Fully Distributed” trading value Apply multiples derived from similar or “comparable”
publicly traded companies to company’s operating statistics
Reliability depends on the level of comparability of other publicly traded companies
o Industry o Range of products o Revenue base (size) o Geographical presence o Profitability o Growth
A change of control premium may be applied to estimate private market value
Precedent Transactions Analysis
Provides private market benchmark in a “change of control” scenario
Does include control premium Apply multiples derived from similar or “comparable”
precedent M&A Transactions o Company’s operating data
Reliability depends on number of recent precedent transactions and their degree of comparability, as well as the relative supply and demand for a certain type of asset at the time of the transaction
Market cycles and volatility may also affect valuation
Discounted Cash Flow Analysis
Theoretical valuation Project the Company’s future operating cash flows for
five ears or more and calculate the present value of those cash flows and of the terminal value methodology
This analysis is heavily dependent on cash flow and growth characteristics of the company, and the terminal value assumption
Leverage Buyout Analysis Determine the range of prices that a financial buyer would be willing to pay for an asset assuming a range of target rates of return
This analysis is heavily dependent on the cash flow profile of the asset exit value assumption
Other Check if there are any other sources of value in a particular transaction
Net operating loss carryforwards (“NOLs”) Synergies Off balance sheet items Break-up value
Different valuation techniques might apply
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M&A Accretion/Dilution Analysis - OverviewM&A Accretion/Dilution Analysis - Overview
Advantages
• Relative Ownership Analysis- Intuitive and straightforward
- Preliminary approach to understand how the companies combine.
• Accretion/Dilution Analysis-Determines effect of the transaction- Primarily focused on EPS
• Value Creation Analysis- Assesses market reaction.
Disadvantages
• Relative Ownership Analysis
- Provides information on transaction consideration that should be further analyzed by accretion/dilution analysis.
• Accretion/Dilution Analysis
- Evaluating synergies can be very subjective
• Value Creation Analysis
- It can be difficult to understand how he market may react to long term strategic objectives.
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Vr = Standalone + Va Vp = Pre-Bid Price + Premium NVA = Va - Premium
◦ Tie into management compensation to projected synergies and real option value
◦ Ensure liquidity available for business plan tied to this
Source: Robert F. Bruner
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• Although there is no right answer, the results of the different valuation methodologies are a useful starting point for structuring a transaction.
The cash flows used for the valuation should be
the same cash flows used for structuring the
transaction
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