1

Vienna MBA Mergers & Acquisitions

Instructor: Adlai Fisher

About the Course

• Mergers, acquisitions, and restructurings – offer a lens into a variety of financial management

practices at a critical time in the life of a corporation– Managers make decisions with guidance from

• Relevant financial theory• Advanced quantitative methods• Careful study of previous business decisions and

outcomes

M&A Foundations• Successful transactions require managers to have solid

understanding of a variety of finance topics and tools– Valuation– Capital structure– Financial distress– Financial statement analysis– Working capital management– Securities markets– Securities issuance– Agency theory– Corporate governance– Executive compensation– Real and financial derivatives– Etc.

4Course Outline• 1: Introduction and M&A Overview, Valuation

– Theoretical frameworks, historical and international perspective, participants

– DCF, multiples, due diligence, wealth effects

– Case: Ducati (Instructor presented)

• 2: Transaction Structuring– Merger legal process, payment method, deal protection, accounting, tax, antitrust

– Case: Seagate

• 3: Hostile Transactions– Takeover strategies and defenses, duties of directors

– Case: Vodafone

5An Example of M&A: MSFT bids for Yahoo

MSFT YahooFeb 1, 2008

$44 Billion

7% 47%

62% premium

The combination also offers an increasingly exciting set of solutions for consumers, publishers and advertisers while becoming better positioned to compete in the online services market

This odd and opportunistic alliance of Microsoft has anything but the interests of Yahoo!'s stockholders in mind

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Vienna MBAMergers and Acquisitions

M&A Overview: Motives and History

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Overview Outline

• M&A objectives, creating shareholder value

• Three theoretical frameworks

• Historical and international perspective

• Current trends

• Participants

• Deal taxonomies

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M&A and Shareholder Value

• Creating shareholder value is the dominant paradigm for thinking about the role of the firm– Ways of increasing shareholder value

• Operations• Finance• Strategy

9

The Corporate Objective Reconsidered• Legal framework

– U.S.: Shareholder value is explicitly the objective– Canada: CBCA expresses goal of maximizing value of the firm (not

necessarily the same)– Europe: broad set of explicit stakeholders– Other areas: China?

• In practice– Managers may have very different incentives than shareholders

(Microsoft / Yahoo)– Other stakeholders can influence decisions

• Employees, trade groups, government, consumers, etc.• E.g., China Petroleum / Unocal

• Inference: Don’t take the corporate objective for granted, likely many interests at stake

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Creating Value

• An acquisition is only one among many possible tactics or strategies

• To create value: focus on areas of expertise or special competencies competitive advantage

• An acquisition may be 1. a well-planned way of achieving a corporate goal

(strategic buyer), and/or2. it may be opportunistic (financial buyer )

• An acquisition generally should not be considered a corporate goal in and of itself

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Bidding Strategies / Winner’s Curse

• Common values auction: all participants get a noisy signal Si = V + ei of true value V– Example: Put cash in envelope, and sealed bid auction to

class. Everyone gets a noisy signal as described above.– What is the equilibrium strategy?– What happens if everyone bids their signal?

• Private values auction: Each individual has a different true value Vi and receives signal Si = Vi + ei– Is the winner’s curse larger or smaller than in common

values auction?

• How does this relate to the bidding strategies of financial and strategic buyers?

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Three frameworks that help us to understand M&A

#1 – Microeconomics

#2 – Principal – Agent Theory

#3 – Financial engineering

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Three Theoretical Frameworks

#1 – Microeconomics• Industry structure is an equilibrium involving

– Technology– Legal and regulatory environment– Macroeconomy

• Dynamics– Slow adjustment: internal investment / disinvestment– Rapid adjustment: M&A becomes more important

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M&A Frameworks

#2 – Principal – Agent Theory• Separation of ownership and management

creates agency costs• When do goals of managers and shareholders

differ?– Mature firm in declining industry– Significant free cash flow (Jensen’s FCF Hypothesis)

• Underperforming firms become takeover targets– LBO’s, MBO’s, and Hostile takeovers– Example: T. Boone Pickens and Mesa Petroleum

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M&A Frameworks

#3 – Financial engineering

• Unlocking value by changing corporate or financial structure– Tax motives (Profitable firm buys company

with NOLs)– Input hedging (e.g., Dupont Conoco) – Risk synergies (debt capacity)

Example: Coca-Cola acquires Huiyuan Juice Corp

Coca HuiyuanSep 3, 2008

$2.4 Billion in Cash

0.2% 167%

3 times Huiyuan’s price

This acquisition will deliver value to our shareholders and provide a unique opportunity to strengthen our business in China.

17% 4%

Notable Deals…

• Magna Int. / Opel, GM division (55% stake, Sept 2009)• Kraft / Cadbury ($17 billion, Sept 2009)• Microsoft intended acquisition to Yahoo ($44 billion, 2008)• Murdoch’s News Corporation/Dow Jones ($5 billion, 2007)• Google / YouTube ($1.65 billion in shares, 2006)• Barrick / Placer ($10.4 billion, hostile then friendly cash and

share tender, 2006)• Sanofi / Aventis ($65 billion, 2004)• Cingular / AT&T Wireless ($41 billion cash, 2004)• JP Morgan / Banc One ($58 billion, 2004)

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Historical Perspective

Merger waves– 1895-1904– 1922-1929– 1940-1947– 1965-1969– 1980’s– 1993-2000 – 2002-2006

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Historical Perspective

1895-1904• Economy

– Rapid economic expansion– Recession begins in 1903

• Technology– Transcontinental railroads permit national markets– Electricity

• Regulatory environment– Permissive– Supreme Court decision in 1903 begins enforcement

of Sherman Act

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Mergers wave around 1900

Source: Mergerstat Review 1989

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Historical Perspective

1895-1904 (cont.)

• Mergers – Mostly horizontal: characterized as “merger

for monopoly”– Concentrated within heavy manufacturing– Forms U.S. Steel, DuPont, Standard Oil, GE,

Kodak– Activity peaks in 1901: result of failure of

some merge

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Historical Perspective

1922-29• Economy

– Rapid economic expansion– Ends around time of crash

• Technology– Automobiles increase consumer mobility, local

distribution– Radio permits product differentiation and

development of national brands• Regulatory environment

– Stricter enforcement against monopolies

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Historical Perspective

1922-29 (cont.)

• Mergers– Characterized as “merger for oligopoly”– Also vertical mergers, product extension,

geographic extension– Concentrated in public utilities, banking, food

processing, chemicals, mining, retailing– IBM, General Foods, Allied Chemical

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Historical Perspective

1940-1947

• Rapid growth of the economy

• Less technological change, smaller merger wave

• Wartime price controls lead to vertical mergers

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Historical Perspective

1960’s Conglomerate Merger Wave • Economy

– Rapid economic expansion– Recession begins in 1971

• Regulatory– Strict antitrust enforcement

• Mergers– At peak in 1967-1968, only 17% of mergers are horizontal or

vertical– Product extension, 60%– Pure conglomerate, 23% (35% of assets)– Roll-ups of many small-medium firms

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Historical Perspective

1960’s Conglomerate Merger Wave (cont.)

• Other possible factors– Theory that these were

defensive/diversification driven: management entrenchment

– Impact of management science– EPS bootstrapping

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Historical Perspective

Example: Ling-Temco-Vought (LTV)• Founder James Ling begins with $2000 investment in

electronics in 1956• Acquisitions:

– American Microwave– J & L Steel– Wilson – sporting goods, meat packing, and pharmaceuticals– Braniff Air – commercial airline– Temco, Vought – military aircraft– National Car Rental– Banks, insurance companies– Altec sound systems

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Historical Perspective

1980’s• Economy

– Expansion begins in earnest in 1984– Recession begins in 1990

• Financial innovation– Junk bonds, LBO’s, MBO’s

• M & A– Characterized as “undoing the conglomerate merger

wave”– Innovation in hostile takeover strategies

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Historical Perspective

1980’s (cont.)

• Sharp decline in 1990-1992– Recession– Adverse court decisions, state anti-takeover

amendments– Failure of junk-bond market and many

leveraged transactions

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Historical Perspective 1960

Source: Houlihan Lokey Howard & Zukin

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Decline of mergers1970

Source: Mergerstat Review 1989

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Mergers from 1980-2006

Source: Thompson Securities Financial Data (SDC)

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Historical Perspective

1993-2000• Economy in rapid economic expansion• Technology

– Telecommunications– Semiconductors, Software– Networking, the internet

• Regulatory environment– Anti-trust policy changing because of convergence of previously

segmented markets– Technological convergence– Geographic convergence: international– Takeover defenses strengthened– Loosening of restrictions in broadcasting, banking, insurance,

utilities

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Historical Perspective

1993-2000 (cont.)

• M&A– Strategic mergers, many across previously

segmented but converging businesses– Most are friendly, increasing stock financing– Divestitures to increase focus

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Historical Perspective

2002-2006• M&As more successful this time around?• Potential explanations:

– Deal management and governance: “Senior management today are much more attuned to shareholder opinions, and are more accountable for demonstrating shareholder value …”

– Better due diligence: “… companies have learned from mistakes that were made in the last two merger waves…”

– Financial synergies and people integration: “Cultural synergies are taken much more seriously than they were in the previous two merger waves.”

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Historical Perspective: Summary

All of the U.S. merger waves are• Associated with economic expansion, and end with recessions• Greatly affected by the regulatory environment

– 1895-1904: Merger for monopoly– 1922-1929: Merger for oligopoly– 1960’s: Conglomerate– 1993-2000: interstate banking, global industrial consolidation

• Greatly affected by technology– 1895-1904: Transcontinental railroads permit concentration of

heavy manufacturing industries– 1922-1929: Radio permits product differentiation and

development of national brands– 1993-2000: telecommunications, semiconductors, the internet

• Financial innovation also plays a role– LBO’s, junk bonds, and the merger wave of the 1980’s: Undoing

the conglomerate merger wave

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International Perspective

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International Perspective

• 1999 Data: Dramatic growth in European, cross-border, and Far Eastern M&A volume– North America: $1.5 trillion– Europe: $1.1 trillion– Asia: $232 billion– South America: $21 billion– Cross border

• North America – Europe: $350 billion• North America – Asia: $54 billion• Europe – South America: $36 billion• Europe – Asia: $31 billion• North America – South America: $18 billion

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European Merger Wage

Source: Thompson Securities Financial Data (SDC)

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Australia Merger Wage

Source: Thompson Securities Financial Data (SDC)

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China Merger Wage

Source: Thompson Securities Financial Data (SDC)

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Japan Merger Wage

Source: Thompson Securities Financial Data (SDC)

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Key Elements of a Successful Deal

The shocking truth: most acquisitions hurt shareholder value!– Search for synergies– Added hurdle of takeover premium

We can generally think of a deal as being composed of four stages:– Strategy– Valuation– Mechanics– Implementation & integration

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The Principal Participants

Buyer / seller– Board of Directors– Managers– Shareholders– Employees

Advisors– Bankers– Lawyers– Accountants– Consultants

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The Principal Participants (cont.)

Regulators– Antitrust– Industry regulators– Securities regulators

Others– Risk arbitrageurs– Short term financiers

All of these parties have separate interests…Inference: Need for leadership and orchestration

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Deal Taxonomies

By economic motivation– Synergies in either costs or revenues– Market power– Wealth transfers from / to shareholders,

debtholders, employees, the government– M&A as a solution to agency problems– M&A as a manifestation of agency problems –

empire building– The winner’s curse and overpayment

Types of Deals

Takeover– The transfer of control from one ownership group to another.

Acquisition– The purchase of one firm or set of assets by another

Merger– The combination of two firms into a new legal entity– A new company is created– Both sets of shareholders have to approve the transaction.

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15 - 48

Types of TransactionsHow the Deal is Financed

Cash Transaction– The receipt of cash for shares by

shareholders in the target company.

Share Transaction– The offer by an acquiring company of shares

or a combination of cash and shares to the target company’s shareholders.

Financial Data Source

1. M&A: Thomson ONE Banker / SDC Platinum (http://toby.library.ubc.ca/resources/infopage.cfm?id=1423 )

2. Financial statement and stock price: Yahoo Finance (http://finance.yahoo.com/ ) Google Finance (http://finance.google.com/finance )

3. Corporate News Factiva (http://toby.library.ubc.ca/resources/infopage.cfm?id=970 )

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Vienna MBAMergers & Acquisitions

Valuation: DCF Methods

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Outline

• DCF valuation techniques– Weighted Average Cost of Capital (WACC)– Adjusted Present Value (APV)

• Capital Cash Flows (CCF)

– Flow to Equity (FTE)

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Weighted Average Cost of Capital

UCF: Unlevered cash flow

0 (1 )t

tt

UCFNPV

WACC

(1 )B B S SWACC w r T w r

UCF EBIT Tax Depreciation Capex WorkingCapital

WACC: After-tax weighted average cost of capital

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Adjusted Present Value (APV)

APV NPVU NPVF

0 (1 )t c

tt B

InterestExpense TNPVF

r

0 0(1 )

tt

t

UCFNPVU

r

•NPVU: NPV of unlevered firm•r0: required return on unlevered firm

•NPVF: NPV of financing side effects•rB: required return on debt

• The NPVF formula above includes only interest tax shields• Ideally, we would also like to capture other financing side effects (but this is often difficult)

• cost of financial distress, financing subsidies, issuing cost• Similar caveat applies to WACC

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Capital Cash Flow Method (CCF)

• You will sometimes hear a valuation method called capital cash flows discussed (e.g., Yell)

• This is just an APV method, where instead of using rB to discount the tax shield benefits of debt, use r0 to discount tax shield benefits of debt.

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Flow to Equity (FTE)

0 (1 )

:Levered cash flow

:Required rate of return on the levered equity

tt

t S

S

LCFNPV

r

LCF

r

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Summary of the Methods

• All the three DCF methods are equivalent in theory

• In practice, some method may be easier, depending on the situation

•WACC and FTE assume constant debt/equity ratio. For time-varying debt/equity ratio, discount rates change each period.•APV uses r0, which does not depend on capital structure.

If debt/equity ratio is constant, then use WACC or FTE

If the dollar value of debt over time is known, then use APV

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Estimating rs

• The primary method of estimating the required return on equity is to use the CAPM. We will focus on this.

• Other models can also be used, e.g., Fama-French, conditional CAPM (time-varying loadings/risk-premia)

58

Using the CAPM

• Beta: Google finance, typically calculated from 1-5 year market model regressions on monthly, weekly, or sometimes daily data

• Risk-free rate: Intermediate or long-term government bond rate, usually chosen to match duration of cash flows Google finance

• The market risk premium: Estimated from medium (10-20 year) to long-run (80 year) averages of excess market returns

•Elaborations: conditioning variables, international data, structural breaks •In practice, typically use values between 3.5% and 7%

( ) [ ]S f M fE r r E r r

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Cautions when using the CAPM to get rs

• Remember that any beta estimate from Google or your own regression reflects the historical risk of the company’s equity

• Equity risk can be changed by altering the financial structure of the company, or the asset mix• Thus, if leverage is changing, or the assets are changing, need to think carefully about how to use historical beta

• Example 1: You have a historical equity beta estimate, and plan to use the same assets going forward, but with a different capital structure.

•Delever to get asset beta, relever for new equity beta

•Example 2: You are changing the asset mix of the company, or the way assets are used

•Find pure play comparables, delever to get asset betas, relever for your own capital structure

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The All-equity cost of capital

0

(1 )

(1 ) (1 )s B

S B Tr r rS B T S B T

Method 1: Use Modigliani-Miller Proposition II, with taxes

Can use solver to obtain r0 or some algebra gives:

0 0

(1 )( )C

s B

B Tr r r r

S

61

MM Proposition II, no taxes

rrBB

rrss=r=r00+B/S(r+B/S(r00-r-rBB))

rrWACC WACC

rr00

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MM Proposition II, with taxes

rrBB

rrss=r=r00+(B/S)(r+(B/S)(r00-r-rBB)(1-T))(1-T)

rrWACCWACC

rr00

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The All-equity cost of capital

0

(1 )

(1 ) (1 )

(if 0)(1 )

E D

E D

S B T

S B T S B T

S

S B T

0 0( ) [ ( ) ]f M fE r r E r r

Method 2: Use the levering and delevering formulas for betas, and the CAPM

Note: you will often see the beta levering/unlevering formula written without (1-T) anywhere. This reflects an assumption that the riskiness of debt tax shields is equal to the risk of the unlevered assets.

64

Example

• Johnson and Johnson operate in several lines of business: Pharmaceuticals, consumer products, and medical devices.

• To estimate the all-equity cost of capital for the medical devices division, we need a comparable, i.e., a pure play in medical devices (we should really have several).

• Data for Boston Scientific:– Equity beta = 0.98

– Debt = $1.3b

– Equity = $9.1b

– Tax rate (T)= 20%

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Example (cont.)

• Compute Boston Scientific’s asset beta (assuming D = 0):

• Let this be our estimate of the unlevered asset beta for the medical devices business.

• Use CAPM to calculate the all-equity cost of capital for that business (assuming 6% risk-free rate, 8% market risk premium):

r0 = 6% + 0.88 *8% = 13.04%

0

9.1 0.98 0.88

(1 ) 9.1 1.3(1 0.2)E

S

S D T

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Which WACC should we use, the acquirer or the target?

• Generally, we use the target WACC. We should adjust the discount rate based on the riskiness of their

investment. The riskiness of an acquisition depends upon the characteristics of

the target, hence, we use target WACC.

• The first exception: the target will be restructured If the acquirer plans to change the operations of the target and this

would have a foreseeable effect on the riskiness of the target cash flows, then we would want to consider this.

• The second exception: the target is private No market data available for WACC. Use the WACC of a publicly traded company that is most similar to

the target. Use the acquirer WACC as a proxy

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Whose capital structure to use, the acquirer or the target?

• Generally, we use the target capital structure. Optimal capital structure is determined by the riskiness of the

underlying assets It is not typically affected by a change of control.

• Again, one exception: the target will be restructured Acquirer projects major changes that will predictably affect the

riskiness of the target cash flows.

• Another exception: risk synergies Two firm’s risk cancels each other. This is a minor issue

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Market values or book values to weight debt/equity?

• The weightings should be based on market values of both debt and equity.

• Because market and book value tend not to be very different for debt, the book value of debt is often used in practice.

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Summary

• Three DCF methods

• If debt-equity ratio is stable over time, use WACC or FTE

• If not, use APV (for LBO, use APV)

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Appendix: Valuation Example

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Singer Company Valuation Example

Consider valuation of Singer company for sale for $475,000

Cash sales: $500,000 per year for indefinite future

Cash costs: 72% of sales

Corporate tax rate: 34%

Cost of capital if unlev 0ered( ): 20%

Interest Rate( ): 10%

Target debt to equity ratio: 1/3B

r

r

Calculate value using•WACC•APV•FTE

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Singer Company WACC ValuationConsider valuation of Singer company for sale for $475,000

Cash sales: $500,000 per year for indefinite future

Cash costs: 72% of sales

Corporate tax rate: 34%

Cost of capital if unlev 0ered( ): 20%

Interest Rate( ): 10%

Target debt to equity ratio: 1/3B

r

r

0 0( / )(1 )( ) 22.2%S C Br r B S T r r

(3/4) 0.222 (1/4) 0.1 0.66 18.3%WACCr

( )(1 ) 92,400UCF Cash Sales Cash Cost Tax Rate

92,400/0.183 475,000 $29,918NPV

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Singer Company APV ValuationConsider valuation of Singer company for sale for $475,000

Cash sales: $500,000 per year for indefinite future

Cash costs: 72% of sales

Corporate tax rate: 34%

Cost of capital if unlev 0ered( ): 20%

Interest Rate( ): 10%

Debt Financing (B): 126,229.5B

r

r

0 ( ) / 462,000uPresent Value of Unlevered FirmV UCF r

475,000 13,000uNPVU V

/ $42,918B C B CNPVF B r T r B T

$29,918APV NPVU NPVF

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Singer Company FTE Valuation

( )(1 ) 84,068.85LCF Cash Sales Cash Cost Interest Expense Tax Rate

/ 84,068.85/0.222 378,688.50sPV LCF r

Purchase cost to equity 475,000 126,229.5 348,770.5

348,770.5 $29,918NPV PV

Consider valuation of Singer company for sale for $475,000

Cash sales: $500,000 per year for indefinite future

Cash costs: 72% of sales

Corporate tax rate: 34%

Cost of capital if unlev 0ered( ): 20%

Interest Rate( ): 10%

Debt Financing (B): 126,229.5B

r

r

Vienna MBAMergers & Acquisitions

Valuation II: Multiples Valuation

Multiples Valuation: Introduction• Basic idea: use prices of a peer group to build up an estimate

of value for the firm you are analyzing (law-of-one-price)

• Outline of typical steps: 1. Choose a relevant peer group (e.g., firms in an industry)

2. Propose a quantity (e.g., EBITDA) that you believe correlates to value (e.g., EV) among firms in the peer group

3. Calculate the corresponding ratio (e.g., λi=EVi/EBITDAi) for all observations i in the peer group

4. Designate the average multiple:

5. Apply this multiple to the firm you are analyzing to estimate its value: 1

/N

iiN

0 0ˆ *V EBITDA

Multiples Valuation: Theory• You are already familiar with the theory behind some important multiples

• E.g., the price-dividend (P/D) ratio:– For a firm i with constant growth of dividends:

, 1,

,

i ti t

i stock D

DP

r g

– Hence:

,

, ,

(1 )i t D

i t i stock D

P g

D r g

Gordon Growth Formula

Thus, the P/D ratio is driven by equity risk (rs) and the growth rate (gD)

P/D Ratio Example• For different values of rs and gD:

rs gD P/D10% 0% 10.010% 2.5% 13.710% 5% 21.015% 0% 6.715% 2.5% 8.215% 5% 10.520% 0% 5.020% 2.5% 5.920% 5% 7.0

• Higher risk (rs) reduces the P/D ratio• Higher growth (gD) increases the P/D ratio

The P/E Multiple• Note That

• Following the Gordon Growth formula again:

• Again shows:– The higher the expected growth rate, g, the higher the P/E

– The higher the required rate of return, r, the lower the P/E

– Changing the payout ratio has two effects: Direct effect in numerator, and indirect effect on g in denominator, which effect dominates depends on the investment opportunities of firm

• Good investment opportunities: High plowback (reducing payout) should maximize P/E

• Poor investment opportunities: High payout should maximize P/E

0 0 011

1 1 1 1

* *Payout RatioP P PD

E D E D

0 1 1

1 1

D Payout Ratio1*

s D s D

P

E r g E r g

Intuition for P/E

• The ratio tells you how many times projected annual earnings (per share) the share is currently trading

• If you buy a company that is trading 10 times projected earnings, it may take 10 years of those earnings to recover your investment.

• If you buy a company trading 100 times projected earnings, it may take 100 years of those earnings to simply recover your investment (excluding time value on your investment).

1

01

10

E

PEPS

ratio P/E JustifiedEPS Estimated

P

The S&P/TSX Composite P/E

Earnings volatility creates wide variations in P/Es associated with the business cycle.

P/E Ratios in the Forest Industry

Company Price 2006 EPS Forecast EPS P/E P/E Forecast

Abitibi 2.72 -0.30 0.12 nm 22.67Canfor 11.13 -0.27 0.47 nm 23.68

Cascades 11.54 0.71 0.60 16.25 19.23

Canfor Pulp 11.56 1.38 1.20 8.38 9.63Catalyst 3.22 -0.07 0.03 nm nmFraser Papers 7.01 -1.35 -0.41 nm nmInternational 6.6 0.26 0.53 25.38 12.45Mercer 9.69 -0.07 0.14 nm 54.35Norbord 8.41 0.74 0.40 10.24 18.95PRT 11.2 0.69 0.70 16.23 16.00SFK Pulp 4.14 0.64 0.82 6.47 5.05Tembec 1.43 -2.00 -1.11 nm nm

P/E is uninformative when company has negative (or small) earnings

Other Ratios Motivated by Theory

• The enterprise value (EV or V) to free cash flow (FCF=UCF) ratio

, 1,

,

i ti t

i WACC UCF

UCFEV

r g

– Hence:

,

, ,

(1 )i t UCF

i t i WACC UCF

EV g

UCF r g

EV/FCF is driven by firm risk (rWACC) and the growth rate (gFCF)

Other Ratios Motivated by Theory

• The enterprise value (EV) to capital cash flow (CCF) ratio

, 1,

,0

i ti t

i CCF

CCFEV

r g

– Hence:

,

, ,0

(1 )i t CCF

i t i CCF

EV g

CCF r g

EV/CCF is driven by unlevered firm risk (r0) and the growth rate (gCCF)

Varieties of Multiples: Numerator and Denominator• In the numerator:

– Enterprise value, denoted V or EV– Equity value, either per share (P) or total market cap (S)

• In the denominator:– Dividends (for P or S)– Aggregate Dividends plus coupon payments (for EV)– FCF=UCF (for EV)– CCF (for EV)– LCF (per share for P, aggregate for S)– EBIT (for EV)– EBITDA (for EV)– Sales/Revenues (for EV)– # of customers, web site hits, # of employees, R&D spending, … (EV)– Book value (of assets for EV, of equity for S, of equity per share for P)– …

Choosing the Numerator (P or EV)

• From theory we know that equity multiples (P) will be determined roughly by– Equity risk rS=r0+(B/S)(r0-rB)(1-T)

– Growth rate of equity cash flows

• Enterprise value multiples (EV) are determined roughly by:– Firm risk (r0 or rWACC)

– Growth rate of FCF, CCF

Includes business risk (r0) andfinancial risk (determined by B/S)

Much less sensitive to capital structure:r0 invariant; rWACC has only tax impacts

Using EV in the numerator has an important advantage:EV ratios are not as sensitive to capital structure and corresponding

variations in equity risk

Choosing the Denominator

• With EV in the numerator, theory encourages us to look at FCF or CCF

• Many other variants that focus on income flows to all claimants– EV/EBIT, EV/EBITDA, EV/(Net Income + interest), etc.– Accounting adjustments can be motivated if they help to smooth noise

in cash flows, providing more accuracy– Other attempts to smooth noise include taking an average of cash

flows, EBIT, or EBITDA over multiple quarters / years

EV/Sales (or P/S)

Advantages– Sales are less sensitive to accounting decisions and are never negative– Not as volatile as earnings– Provides information about corporate decisions such as pricing

Disadvantage– Does not include information about expenses and profit margins which

are key determinants of corporate performance

Usually driven by industry that is not currently profitable (e.g., internet companies in late 90’s)

Other multiples based on profit potential (sometimes distant):

• customers, geographic coverage, web site hits, etc.

EV/Assets• The other main type of denominator is based on assets

• E.g., the ratio EV/(Book Value of Assets) is closely related to a theoretically motivated measure called Tobin’s Q

Market Value of Assets (EV)

Replacement Cost of Assetsq

q provides a ratio describing value added by the firm

• When Market/Book uses equity in the numerator and denominator, it is the inverse of the B/M ratio in the Fama-French 3-factor model

Choosing the Peer Group

• The first, and perhaps most important, step in multiples valuation is choosing a peer group

• Most commonly, peer group chosen by industry and country / geography of primary business location– 4 digit SIC codes, NAIC codes, Fama-French industry definitions, Yahoo

or Google stock screener industry definitions, etc.– Choose firms that are legitimately in a similar line of business, that one

would expect to have similar profit profiles and risk characteristics– If EV in numerator, not essential that peers have similar capital

structures; for equity multiples, capital structure is an important control.

Two Primary Variants• Trading Multiples: Common general purpose technique

– Calculate multiples for peers based on the current trading values of equity and, where available, debt (otherwise can use book for debt)

– Typically require that peers are publically traded so that market value of equity can be obtained– Discounts sometimes applied for illiquidity if the firm being valued is not publically traded.– Does not include a control premium

• Transaction Multiples: Used in M&A settings– Based on relatively recent transactions involving purchases or acquisitions of peer group firms– Peer group transactions may be public or private– Generally harder to find good peer comparisons, and sometimes the transactions are older than we

would like – Includes a control premium

Strengths and Weaknesses of Multiples Valuation

• Strengths– Simple, easy to use, easy to understand– Incorporates current information on how the market values peer firms

• Weaknesses– Multiples are based on relative valuation and are only accurate if the market values

other firms correctly– By contrast, DCF methods use absolute valuation, and do not rely on the market’s

valuations of peer firms– Paradox: if all investors use only relative valuation, then nothing ties down the price

level and the market becomes inefficient• Use of relative valuation methods is often cited as an important contributor to speculative

bubbles (internet bubble, housing bubble, etc.)

Choosing a Multiple to Use

• For any industry/situation, there are often a number of potential multiples one could use– EV/EBITDA, EV/FCF, EV/sales, EV/Assets, etc.

• To compare accuracy of different multiples within peer group, interpret multiples valuation as a restricted (zero intercept) regression:

Combining Information in Different Multiples

• Suppose we have several multiples that seem to work well– One ad hoc way to combine information is to calculate implied values from each

multiple, and average– A more systematic way to approach the problem is to run a multiple regression, e.g.

0 1 2 3 &i i i i iEV a a CCF a Assets a R D

Need to check the correlation of your regressors in first regression and collinearity diagnostics if two or more are very closely related.

Obtain estimates of regression coefficients using peers, and apply these coefficients to the corresponding variables for firm being analyzed:

0 0 1 0 2 0 3 0ˆ ˆ ˆ ˆ ˆ &V a a CCF a Assets a R D

Which to Use, DCF or Multiples?

Often, both are valuable– Intuitively, DCF more accurate for projects with easy to forecast

cash flows (e.g., infrastructure projects), and where the purchase will be buy and hold

– Multiples may tend to be more often used when cash flows are difficult to predict, and the asset will be sold at current market valuations (e.g., IPO)

Appendix

Example

Sales $10 M

EBITDA $ 3.3 M

EBIT $2.5 M

Net Income $ 1 M

# of shares $0.5 M

Debt $5 M

Equity $5 M

Market Value of Equity $15 M

Consider the following target firm

Ratio T1 T1 5-Yr. Avg. Ind. Avg.

P/E 15 X 14.5 16.5

Value/EBIT 8 X 5.5 7.5

Value/EBITDA 6.06 4.8 6

P/Sales 1.5X 1.35 1.6

P/Book 3 X 3 3.2

Example

Using the industry average as the justifiable multiples

P/E P/E * Net Income 16.5 *1M= 16.5 M

V/EBIT V/EBIT * EBIT – Debt 7.5*2.5 – 5 = 13.75 M

V/EBITDA V/EBITDA *EBITDA–Debt 6*3.3 － 5=14.8 M

P/Sales P/Sales * Sales 1.6*10=16 M

P/Book P/B*Book Value 3.2*5=16 M

Using the 5 Yr. average as the justifiable multiples

P/E P/E * Net Income 14.5 *1M= 14.5 M

V/EBIT V/EBIT * EBIT – Debt 6.5*2.5 – 5 = 11.25 M

V/EBITDA V/EBITDA *EBITDA–Debt 4.8*3.3 － 5=10.8 M

P/Sales P/Sales * Sales 1.35*10=13.5 M

P/Book P/B*Book Value 3*5=15 M

Multiples Using Number of Employees

This sample used for all plots in this file is all Compustat firms in 2007. Each dot represents a firm. The regression line is restricted to have an intercept of zero.

Multiples Valuation Using Sales

Multiples Valuation Using EBIT

Multiples Valuation Using EBITDA

Multiples Valuation Using Book Value of Assets

Cross-Industry Comparison of R2 from Regressions of EV on other variables

# of Employees

Sales EBIT EBITDA Assets

Manufacturing

0.42 0.67 0.67 0.70 0.72

Mining 0.16 0.87 0.88 0.86 0.79Retail 0.90 0.92 0.97 0.97 0.94Info. Tech.

0.54 0.61 0.48 0.35 0.58

Finance and Insurance

0.82 0.84 0.66 0.68 0.73

This table reports R2 from univariate regressions of enterprise value (EV) on each of the variables listed in the column headings. The initial sample is all Compustat firms in the 2007 data, and in each row the sample is restricted only to firms in that industry.

Cross-Industry Comparison: Regression Coefficient

# of Employees

Sales EBIT EBITDA Assets

Manufacturing 545.7 1.05 7.53 5.95 1.13Mining 559 2.44 6.99 5.35 1.10Retail 106 0.57 10.20 7.90 1.26Info. Tech. 663.3 2.11 10.25 5.22 0.85Finance and Insurance

899 1.34 2.86 2.81 0.09

This table reports the regression coefficients from univariate regressions of enterprise value (EV) on each of the variables listed in the column headings. The initial sample is all Compustat firms in the 2007 data, and in each row the sample is restricted only to firms in that industry.

106

Vienna MBAMergers & Acquisitions

M&A Wealth Effects

107

Overview

• Large literature in finance studying the wealth and performance effects of M&A activity– E.g., Event Studies– Findings: Basic Wealth Effects in M&A

• The Market Timing Hypothesis and Stock Market Driven Acquisitions

• Extras

108

Three approaches to measure M&A profitability

1. Event studies (most used in finance)

2. Accounting studies

3. Surveys of executives ( seldom used in finance)

Procedures of event study1. Identify the event of interest. (e.g., M&A, CEO turnover)

2. Define the event period? (e.g., -1 days and +1 day)

3. Compute the real stock return

4. Measure “normal” return using asset pricing model (CAPM, APT, Fama-French, etc)

5. Abnormal return= real return – “normal” return

6. Sum up abnormal return to get cumulative abnormal returns

110

Example of an event study

Merrill Lynch

$50 Billion in StockBank of America

Sep. 15, 2008

Date Rm (S&P500)

R (BA) AR(BA)=R(BA)-Rm

R (ML) AR( ML)=R(ML)-Rm

16-Sep 1.75% 11.30% 9.55% 30.01% 28.26%

15-Sep -4.71% -21.31% -16.60% 0.06% 4.77%

12-Sep 0.21% 2.06% 1.84% -12.25% -12.46%

Firm Accumulative abnormal returns (CAR3)

MV Equity Dollar Gain/Loss

BM -7.95% $ 155 Billion － $12.3 Billion

ML 17.8% $ 37 billion +$6.6 Billion

111

Assumptions for event studies

• Event is unanticipated– Abnormal returns are result of reaction

• No confounding effects– Eliminate other events

• Markets are efficient (recall 3 forms of EMH hypothsis)– Weak ( all past price and trading information)– Semi-strong (all publicly known and available information)– Strong (both public and private information)

112

Event studies

Strengths: • A relatively direct measure of value to

shareholders• A forward-looking measure

Weaknesses:• Requires strong assumptions• Vulnerable to confounding events…

113

Findings: Wealth effects for Bidders

– Approximately zero returns to successful bidders

– Possibly higher return to bidders in tender offers (+4%) than in mergers (+0%)

– Slightly positive in 60s (+5%) and 70s (+2%), and slightly negative in 80s (-1%)

– Very negative during late 90s and early 2000s

114

Wealth effects: Targets

• Target shareholders gain

• Tender offer vs. merger

– Aggregate 30% abnormal return to targets in tender offers

– 20% abnormal return to “targets” in mergers

115

Predictive Ability of CAR

• If negative bidder returns on announcement– Future divestiture is more likely– The acquirer is more likely to become a target

itself

• Positive event returns produce the opposite

116

Failed Transactions• Both bidder and target have negative CAR after

unsuccessful tender offer

• Market’s initial reaction predict outcomes– Targets of failed tender offers who are acquired within the next 60

days had the most positive initial announcement effects (50% compared to 23% for others)

• For unsuccessful bidders– If the target is acquired by another buyer in first 180 days, negative

returns for initial bidder (CAR 0 to 180) are –8%– If the target is not acquired by another firm, the CAR (0 to 180) for

the initial bidder is zero.

The market is suspicious of both

Market reacts most positively initially for targets who are most attractive in general

Suggests that the market believes there is a problem with the buyer when deal fails and target is acquired by different firm

117

Financing

Higher abnormal returns for targets in cash offers than stock offers

– information effect (bidders use cash when they are more confident)

– Also possibly tax effect (higher premium may be needed since cash transactions taxed immediately, stock not)

118

Timing

– Average time between announcement and completion of acquisition is 66 days

– Twice as long for completion when securities are involved as opposed to an all cash transaction

119

Multiple bidders

– When multiple bidders arise• Target CAR +26% on day 1, +45% to day 80

– For a single bidder• Target CAR +26% on day 1, +26% to day 80

– Initial acquirer loses 2.4% when a second bid is announced

120

Predictors of Hostile vs. Friendly Structure

• Insider ownership– Tends to be low in targets that get hostile bids– High in targets that get friendly bids

• Previous performance of target– Below average in hostile deals– Above average in friendly deals

121

Surveys of managers

• Bruner (2002) conducted his own survey. According to the respondents:

• 37% of deals create value for the buyer• 21% of deals achieve their strategic goals

122

An important caveat

• Impossible to empirically test if stakeholders would have been better off if no M&A activity; hence, full tests of value of M&A activity are impossible.

123

So, does M&A pay? Summary of findings

• Target firms: significant positive returns• Acquirer firms: no value creation (NPV=0), on average.

– IF Cash offer: zero or slightly positive returns– IF stock offer: negative returns

• Note: acquirer is typically larger in size. Therefore % effect of acquisition is smaller for acquirer, all else being equal

• Combined Target and Acquirer: – value is created, NPV > 0

124

II. Market Timing and Stock Mergers

Discussion based on Moeller, Schlingemann, and Stulz, Journal of Finance (2005)…

125

Dollar Gain/Loss ($M) in M&A 1980-1997

Source: Moeller, Schlingemann, Stulz, Journal of Finance (2005)

126

Dollar Gain/Loss ($M) in M&A 1998-2001

Source: Moeller, Schlingemann, Stulz, Journal of Finance (2005)

127

Dollar Gain/Loss ($M) in M&A 1980-2001

Source: Moeller, Schlingemann, Stulz, Journal of Finance (2005)

Puzzle

128

129

Market timing

Good performance

Bad performance

If manager has private information, in which situation should she issue equity?

What is the stock market reaction?Negative stock reaction when firms issue equityPositive stock reaction when firms repurchase equity

130

• Current MV= 100 shares × $10/share=$1000

• Fundamental MV = 100 × $1/share=$100

• Manager issues equity of $200 to undertake acquisitions

Stock market driven acquisition

No Learning

Issuing Price 10

Shares Issued

200/10 =20

Price (Short term)

10

Price (Long term)

(100+200)/120=2.5

Full Learning

1

200/1=200

1

(100+200)/300=1

Partial Learning

5

200/5=40

5

(100+200)/140=2.1

Without merger, more negative bidder return

Information asymmetry

131

• Overvalued bidders use equity to acquire real assets from target

• Stock price of bidders go down during the merger

• But the merger still serves the interests of bidder shareholders, because the bidder’s stock return would be more negative without the merger.

• Most evident in the later 1990s (Internet bubble).

Stock market driven acquisition

132

III. Extras

…

CARs for Successful and Unsuccessful Bidders

Full sample: 1,815 deals. 1,401 successfully (dotted line), and 414 Unsuccessful (dashed line). Period 1971-1991.

Source: Schwert, Journal of Financial Economics, (1996), Markup Pricing in M&A

A Refinement of Bidder Returns

Bidder CAR(-1,1) for deals in 1980 – 2005Large and small are the upper and lower quartile of market cap at -42.

Source: Eckbo, Betton, and Thorburn, Handbook of Empirical Corporate Finance (2008)

135

• Does M&A Pay? (NY Times)

• New Merger Wave?

– CNN

– NY Times

Some Links