valuation for mergers & acquisitions

Prof. Ian GiddyNew York University

Valuationfor Mergers & Acquisitions

Copyright ©2000 Ian H. Giddy Valuation for M&A 2

What’s a Company Worthto Another Company?

Required Returns Types of Models

Balance sheet modelsDividend discount & corporate cash flow

modelsPrice/Earnings ratiosOption models

Estimating Growth Rates Application: How These Change with

M&A

IpohIpoh


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 ValueLiquidation

ValueReplacement

ValueTobin’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!


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

Value = CFt

(1+ r)tt =1

t = n


Valuing a Firm with DCF: An Illustration

Historical financial results

Adjust for nonrecurring aspects

Gauge future growth

Adjust for noncash items

Projected sales and operating profits

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

Present value of free cash flows

+ cash, securities & excess assets

- Market value of debt

Value of shareholders equity

…

Discount to present using weighted average cost of capital (WACC)


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.

Value of Equity = CF to Equityt

(1+ ke )tt=1

t=n


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

Value of Firm = CF to Firmt

(1+ WACC)tt=1

t=n


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.


The Weighted Average Cost of Capital

Choice Cost1. 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)]


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:

Value = CF

t

(1+ r)tt = 1

t =

Value = CFt

(1 + r)t

Terminal Value

(1 + r)N

t = 1

t = N


Dividend Discount Models:General Model

VD

ko

t

tt

( )11

VD

ko

t

tt

( )11

V0 = Value of Stock Dt = Dividend k = required return


Specified Holding Period Model

01

12

2

1 1 1V D

kD

kD P

kN N

N

( ) ( ) ( )...

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

VD

ko

Stocks that have earnings and dividends that are expected to remain constant

Preferred Stock


No Growth Model: Example

E1 = D1 = $5.00

k = .15

V0 = $5.00 / .15 = $33.33

VD

ko

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?

Burlington Power & Light has earnings of $5 per share and pays out 100% dividend


The earnings are not expected to grow but remain steady indefinitely

What’s a BPL share worth?


Constant Growth Model

VoD g

k g

o

( )1Vo

D g

k g

o

( )1

g = constant perpetual growth rate


Constant Growth Model: Example

VoD g

k g

o

( )1Vo

D g

k g

o

( )1

E1 = $5.00b = 40% k = 15%

(1-b) = 60% D1 = $3.00 g = 8%

V0 = 3.00 / (.15 - .08) = $42.86

Motel 6 has earnings of $5 per share. It reinvests 40% and pays out 60%dividend


The earnings are expected to grow at 8% per annum

What’s an M6 share worth?

Motel 6 has earnings of $5 per share. It reinvests 40% and pays out 60%dividend


The earnings are expected to grow at 8% per annum

What’s an M6 share worth?

Plowback rate


Estimating Dividend Growth Rates

g ROE b g ROE b

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

V Dg

k

D g

k g ko o

t

tt

TT

T

( )

( )

( )

( )( )

1

1

1

1

1

1

2

2V D

g

k

D g

k g ko o

t

tt

TT

T

( )

( )

( )

( )( )

1

1

1

1

1

1

2

2

g1 = first growth rate

g2 = second growth rate

T = number of periods of growth at g1


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?

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?

Shifting Growth Rate Model: Example

D0 = $2.00 g1 = 20% g2 = 5%

k = 15% T = 3 D1 = 2.40

D2 = 2.88 D3 = 3.46 D4 = 3.63

V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3

+ D4 / (.15 - .05) ( (1.15)3

V0 = 2.09 + 2.18 + 2.27 + 23.86 = $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.


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)


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


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


The Building Blocks of Valuation

Choose aCash Flow Dividends

Expected Dividends to

Stockholders

Cashflows to Equity

Net Income

- (1- ) (Capital Exp. - Deprec’n)

- (1- ) Change in Work. Capital

= Free Cash flow to Equity (FCFE)

[ = Debt Ratio]

Cashflows to Firm

EBIT (1- tax rate)

- (Capital Exp. - Deprec’n)

- Change in Work. Capital

= Free Cash flow to Firm (FCFF)

& A Discount Rate Cost of Equity

Basis: The riskier the investment, the greater is the cost of equity.

Models:

CAPM: Riskfree Rate + Beta (Risk Premium)

APM: Riskfree Rate + Betaj (Risk Premiumj): n factors

Cost of Capital

WACC = ke ( E/ (D+E))

+ kd ( D/(D+E))

kd = Current Borrowing Rate (1-t)

E,D: Mkt Val of Equity and Debt

& a growth pattern

t

g

Stable Growth

g

Two-Stage Growth

|High Growth Stable

g

Three-Stage Growth

|High Growth StableTransition


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


Price Earnings Ratios

P/E Ratios are a function of two factorsRequired rates of return (k)Expected growth in dividends

UsesRelative valuationExtensive 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,

P 0 DPS1

r gn

P0

EPS0PE =

Payout Ratio * (1 gn )

r-gn

P 0

BV0PBV =

ROE - gn

r-gn

P 0

BV0PBV =

ROE * Payout Ratio * (1 gn )

r-gn

P 0

Sales 0PS =

Profit Margin * Payout Ratio * (1 gn )

r-gn


P/E Ratio: No expected growth

PE

kP

E k

01

0

1

1

PE

kP

E k

01

0

1

1

E1 - expected earnings for next yearE1 is equal to D1 under no growth

k - required rate of return


P/E Ratio with Constant Growth

PD

k g

E b

k b ROE

P

E

b

k b ROE

01 1

0

1

1

1

( )

( )

( )

PD

k g

E b

k b ROE

P

E

b

k b ROE

01 1

0

1

1

1

( )

( )

( )

Where b = retention ratio ROE = Return on Equity


Numerical Example: No Growth

E0 = $2.50 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?

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/(.125-.09) = $31.14

PE = 31.14/2.73 = 11.4

PE = (1 - .60) / (.125 - .09) = 11.4


Disney: Relative Valuation

Company PE Expected Growth PEG

King World Productions 10.4 7.00% 1.49

Aztar 11.9 12.00% 0.99

Viacom 12.1 18.00% 0.67

All American Communications 15.8 20.00% 0.79

GC Companies 20.2 15.00% 1.35

Circus Circus Enterprises 20.8 17.00% 1.22

Polygram NV ADR 22.6 13.00% 1.74

Regal Cinemas 25.8 23.00% 1.12

Walt Disney 27.9 18.00% 1.55

AMC Entertainment 29.5 20.00% 1.48

Premier Parks 32.9 28.00% 1.18

Family Golf Centers 33.1 36.00% 0.92

CINAR Films 48.4 25.00% 1.94

Average 27.44 18.56% 1.20

PE ratio divided

by the growth rate


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? Under Valued Over Valued Correctly Valued

Will this valuation give you a higher or lower valuation than the discounted CF valuation? Higher Lower


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

Equity Valuation:Application to M&A

Prof. Ian GiddyNew 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 Financial

restructuring

Business

Restructuring

(M&A)

Bottom line


Framework for Assessing Retructuring Opportunities

RestructuringFramework

1

2

CurrentMarketValue

3

Totalrestructuredvalue

Potentialvalue withinternal+ externalimprovements

Potentialvalue withinternalimprovements

Company’sDCF value

Maximumrestructuringopportunity

Financialstructureimprovements

4

Disposal/Acquisitionopportunities

Operatingimprovements

Current marketoverpricing orunderpricng

5

(Eg Increase D/E)


Equity Valuation in Practice

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


Optika OptikaGrowth 5%Tax rate 35%Initial Revenues 3125COGS 89%WC 10%Equity Market Value 1300Debt Market Value 250Beta 1Treasury bond rate 7%Debt spread 1.5%Market risk premium 5.50%

T+1Revenues 3281-COGS 2920-Depreciation 74=EBIT 287EBIT(1-Tax) 187-Change in WC 16=Free Cash Flow to Firm 171Cost of Equity (from CAPM) 12.50%Cost of Debt (after tax) 5.53%WACC 11.38%

Firm Value 2278

CAPM:

7%+1(5.50%)

Debt cost

(7%+1.5%)(1-.35)

WACC:

ReE/(D+E)+RdD/(D+E)

Value:

FCFF/(WACC-growth rate)

Equity Value:

Firm Value - Debt Value

= 2278-250 = 2028


Optika & SchirndingSchirnding-Optika

Optika Schirnding CombinedGrowth 5% 5% 5%Tax rate 35% 35% 35%Initial Revenues 3125 4400 7525COGS 89% 87.50%WC 10% 10% 10%Equity Market Value 1300 2000 3300Debt Market Value 250 160 410Beta 1 1 1Treasury bond rate 7% 7% 7%Debt spread 1.5% 1.5% 1.5%Market risk premium 5.50% 5.50% 5.50%

T+1 T+1Revenues 3281 4620 7901-COGS 2920 4043 6963-Depreciation 74 200 274=EBIT 287 378 664EBIT(1-Tax) 187 245 432-Change in WC 16 22 38=Free Cash Flow to Firm 171 223 394Cost of Equity (from CAPM) 12.50% 12.50% 12.50%Cost of Debt (after tax) 5.53% 5.53% 5.53%WACC 11.38% 11.98% 11.73%

Firm Value 2278 3199 5859


Optika-Schirnding with SynergySchirnding-Optika

Optika Schirnding Combined SynergyGrowth 5% 5% 5% 5%Tax rate 35% 35% 35% 35%Initial Revenues 3125 4400 7525 7525COGS 89% 87.50% 86.00%WC 10% 10% 10% 10%Equity Market Value 1300 2000 3300 3300Debt Market Value 250 160 410 410Beta 1 1 1 1Treasury bond rate 7% 7% 7% 7%Debt spread 1.5% 1.5% 1.5% 1.5%Market risk premium 5.50% 5.50% 5.50% 5.50%

T+1 T+1 T+1Revenues 3281 4620 7901 7901-COGS 2920 4043 6963 6795-Depreciation 74 200 274 274=EBIT 287 378 664 832EBIT(1-Tax) 187 245 432 541-Change in WC 16 22 38 38=Free Cash Flow to Firm 171 223 394 503Cost of Equity (from CAPM) 12.50% 12.50% 12.50% 12.50%Cost of Debt (after tax) 5.53% 5.53% 5.53% 5.53%WACC 11.38% 11.98% 11.73% 11.73%

Firm Value 2278 3199 5859 7479Increase 1620


Optika-Schirnding with SynergySchirnding-Optika

Optika Schirnding Combined SynergyGrowth 5% 5% 5% 5%Tax rate 35% 35% 35% 35%Initial Revenues 3125 4400 7525 7525COGS 89% 87.50% 86.00%WC 10% 10% 10% 10%Equity Market Value 1300 2000 3300 3300Debt Market Value 250 160 410 410Beta 1 1 1 1Treasury bond rate 7% 7% 7% 7%Debt spread 1.5% 1.5% 1.5% 1.5%Market risk premium 5.50% 5.50% 5.50% 5.50%

T+1 T+1 T+1Revenues 3281 4620 7901 7901-COGS 2920 4043 6963 6795-Depreciation 74 200 274 274=EBIT 287 378 664 832EBIT(1-Tax) 187 245 432 541-Change in WC 16 22 38 38=Free Cash Flow to Firm 171 223 394 503Cost of Equity (from CAPM) 12.50% 12.50% 12.50% 12.50%Cost of Debt (after tax) 5.53% 5.53% 5.53% 5.53%WACC 11.38% 11.98% 11.73% 11.73%

Firm Value 2278 3199 5859 7479Increase 1620

Case Study: Ipoh-Kelantan


Ipoh-KelantanIpoh-Kelantan Bank

Ipoh KelantanRevenues RM4,400.00 RM3,125.00Cost of Goods Sold (w/o Depreciation)as % of Revenue Depreciation RM200.00 RM74.00Tax Rate 35.00% 35.00%

10% of 10% of Revenue Revenue

Market Value of EquityOutstanding debt RM160.00 RM250.00

Now estimate the value of the merged bank, assuming synergies.

What is the value of the combined bank? Is Kelantan overpaying?

As part of the consolidation of banks in Malaysia, Bank of Ipoh and Kelantan Bank Holdings Bhd are planning a merger. The proposed merger will occur through an exchange of shares, with Kelantan paying 1.5 shares for each share of Ipoh. Ipoh shares are cur

The following are the details of the two potential merger candidates (RM figures in millions):

87.50% 89.00%

As a result of the merger, the combined firm is expected to have a cost of goods sold of only 86% of total revenues. earnings will grow faster, at 6%. The combined firm does not plan to borrow additional debt.

Estimate the value of Ipoh and of Kelantan, operating independently. Then estimate their combined value, assuming no synergies. If it does not increase debt, the combined firm's rating will be A+ (with an interest rate of 7.75%)

Finally, assume that, as a result of the merger, the Ipoh-Kelantan Bank's optimal debt ratio increases to 20% of total capital from current levels. (At that level of debt, the combined firm will have an A rating, with an interest rate on its debt of 8%.)

Working Capital

RM2,000.00 RM1,300.00

Both firms are in steady state and are expected to grow by 5% a year in the long term. Capital spending is expected to be 90% of depreciation. The beta for Ipoh is 1.7, and for Kelantan 1.5, and both firms are rated BBB, with an interest rate on their deb


AppendixCorporate 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.

Value of Firm = CF to Firmt

(1+ WACC) tt =1

t= n


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.


Cashflow to FirmEBIT (1-t)- (Cap Ex - Depr)- Change in WC= FCFF

Expected GrowthReinvestment Rate* Return on Capital

FCFF1 FCFF2 FCFF3 FCFF4 FCFF5

Forever

Firm is in stable growth:Grows at constant rateforever

Terminal Value= FCFF n+1/(r-gn)

FCFFn.........

Cost of Equity Cost of Debt(Riskfree Rate+ Default Spread) (1-t)

WeightsBased on Market Value

Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))

Value of Operating Assets+ Cash & Non-op Assets= Value of Firm- Value of Debt= Value of Equity

Riskfree Rate :- No default risk- No reinvestment risk- In same currency andin same terms (real or nominal as cash flows

+Beta- Measures market risk X

Risk Premium- Premium for averagerisk investment

Type of Business

Operating Leverage

FinancialLeverage

Base EquityPremium

Country RiskPremium

DISCOUNTED CASHFLOW VALUATION


Estimating Cash Flows to Firm

EBIT ( 1 - tax rate)

- (Capital Expenditure - Depreciation)

- Change in Non-Cash Working Capital

= Cash flow to the firm

Alternatively,

EBIT ( 1 - tax rate)

- Reinvestment Needs

= Cash flow to the firm


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 (2 - 10 years)Collect past R&D expenses for as long as the

amortizable lifeSum 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 $ Value1998 1385.00 1.00 1385.001997 1276.00 0.90 1148.401996 1199.00 0.80 959.201995 1108.00 0.70 775.601994 1128.00 0.60 676.801993 1083.00 0.50 541.501992 983.00 0.40 393.201991 881.00 0.30 264.301990 789.00 0.20 157.80

1989 688.00 0.10 68.80

Value of research asset = $ 6,371 millionAmortization of research asset in 1998 = $ 637 millionAdjustment 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 3EBIT 500 500 500TaxesEBIT (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 asCurrent operating income is positiveCurrent 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.


A Framework for Analyzing Companies with Negative or Abnormally Low Earnings

Why are the earnings negative or abnormally low?

TemporaryProblems

Cyclicality:Eg. Auto firmin recession

StructuralProblems: Eg. Cable co. with high infrastruccture investments.

LeverageProblems: Eg. An otherwise healthy firm with too much debt.

Long-termOperatingProblems: Eg. A firm with significant production or cost problems.

Normalize Earnings

Value the firm by doing detailed cash flow forecasts starting with revenues and reduce or eliminate the problem over time.:(a) If problem is structural: Target for operating margins of stable firms in the sector.(b) If problem is leverage: Target for a debt ratio that the firm will be comfortable with by end of period, which could be its own optimal or the industry average.(c) If problem is operating: Target for an industry-average operating margin.

If firm’s size has notchanged significantlyover time

Average DollarEarnings (Net Income if Equity and EBIT if Firm made bythe firm over time

If firm’s size has changedover time

Use firm’s average ROE (if valuing equity) or average ROC (if valuing firm) on current BV of equity (if ROE) or current BV of capital (if ROC)


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 (1-.3345) = 107 million

- (Capital Spending - Depreciation) = 118 - 70 = 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)

= (48 + 25)/ 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

Choose aCash Flow Dividends

Expected Dividends to

Stockholders

Cashflows to Equity

Net Income

- (1- ) (Capital Exp. - Deprec’n)

- (1- ) Change in Work. Capital

= Free Cash flow to Equity (FCFE)

[ = Debt Ratio]

Cashflows to Firm

EBIT (1- tax rate)

- (Capital Exp. - Deprec’n)

- Change in Work. Capital

= Free Cash flow to Firm (FCFF)

& A Discount Rate Cost of Equity

Basis: The riskier the investment, the greater is the cost of equity.

Models:

CAPM: Riskfree Rate + Beta (Risk Premium)

APM: Riskfree Rate + Betaj (Risk Premiumj): n factors

Cost of Capital

WACC = ke ( E/ (D+E))

+ kd ( D/(D+E))

kd = Current Borrowing Rate (1-t)

E,D: Mkt Val of Equity and Debt

& a growth pattern

t

g

Stable Growth

g

Two-Stage Growth

|High Growth Stable

g

Three-Stage Growth

|High Growth StableTransition


Current Cashflow to FirmEBIT(1-t) : 107- Nt CpX 48- Chg WC 25= FCFF 34Reinvestment Rate =67.66%

Expected Growth in EBIT (1-t).6766*.1613= .109110.91 %

Stable Growthg = 5%; Beta = 0.80;kd=9.75%

Country Risk Premium=2.5%ROC=16.13%Reinvestment Rate=31.01%

Terminal Value 5= 131/(.1207-.05) = 1847

Cost of Equity17.38%

Cost of Debt(6%+ 5.25%+1.25%)(1-.3345)= 8.32%

WeightsE = 94.37% D = 5.63%

Discount at Cost of Capital (WACC) = 17.38% (0.9437) + 8.32% (0.0563) = 16.87%

Firm Value: 996+ Cash: 11- Debt: 59=Equity 948-Options 0Value/Share $3.05

Riskfree Rate :Government Bond Rate = 6%

+Beta 0.71 X

Risk Premium16.03%

Unlevered Beta for Sectors: 0.68

Firm’s D/ERatio: 5.97%

Historical US Premium5.5%

Country RiskPremium10.53%

Siderar: A ValuationReinvestment Rate67.66%

Return on Capital16.13%

EBIT(1-t)- ReinvFCFF

119 81 39

132 89 43

146 99 47

162110 53

180122 58


AppendixKey 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

Net Income

Total Assets


Profitability Ratios

Return on Equity

Net Income

Common Equity

Operating Margin After Depr.

Operating Profit

Sales


Decomposition of ROE

ROE =ROE = Net ProfitNet Profit

Pretax ProfitPretax Profit

xx

Pretax Pretax ProfitProfit

EBITEBIT

xxEBITEBIT

SalesSales

SalesSales

AssetsAssetsxx xx

AssetsAssets

EquityEquity

(1) x (2) x (3) x (4) x (5) (1) x (2) x (3) x (4) x (5)

x Margin x Turnover x Leveragex Margin x Turnover x Leverage TaxTax

BurdenBurden

InterestInterest

BurdenBurden

xx


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?


AppendixValuation Using the Options Approach

Present Value of Expected Cash Flows if Option Excercised

Value of the Firm or project


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

Present Value of Expected Cash Flows on Product

PV of Cash Flows from Project

Initial Investment in Project

Project has negativeNPV in this section

Project's NPV turns positive 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

Present Value of Expected Cash Flows on Expansion

PV of Cash Flows from Expansion

Additional Investment to Expand

Firm will not expand inthis section

Expansion becomes attractive in 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)

whereSo = 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


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

Tel 212-998-0332; Fax 212-995-4233

[email protected]

http://www.giddy.org

valuation for mergers & acquisitions

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