Valuation of Mergers and Acquisitions SUBMITTED BY: DEBAYAN MUKHERJI PGDM ‘”2008-2010 ROLL NO: 08PGDM083 INTERNATIONAL MANAGEMENT INSTITUTE, NEW DELHI CONTACT NUMBER: 09717443910 EMAIL : debayan. p08@imi. edu Valuation of Mergers and Acquisitions Mergers and acquisitions (more generally, takeovers) are an important means through which companies achieve economies of scale, face the competition, or respond to economic shocks. For example ,how the $54 billion US chemical major Dow Chemicals is in process of acquiring its rival Rohm and Haas(R&H) for a total consideration of $18. 8 billion, can be seen.
Not surprisingly, these actions often make the news. Deals can be worth hundreds of millions, or even billions, of dollars. They can dictate the fortunes of the companies involved for years to come. For a CEO, leading an M&A can represent the highlight of a whole career. And it is no wonder we hear about so many of these transactions; they happen all the time. ?? A merger is a combination of two or more corporations in which only one corporation survives and the merged corporations go out of business. ?? Statutory merger is a merger where the acquiring company assumes the assets and the liabilities of the merged companies A subsidiary merger is a merger of two companies where the target company becomes a subsidiary or part of a subsidiary of the parent company Varieties of Mergers From the perspective of business structures, there??is a whole host of different mergers. Here are a few types, distinguished by the relationship between the two companies that are merging: ?? Horizontal merger??- Two companies that are in direct competition and share??the same product lines and markets. ?? Vertical merger??- A customer and company or a supplier and company. Think of a cone supplier merging with an ice cream maker. Market-extension merger -??Two companies that sell the same products in different markets. ?? Product-extension merger – Two companies selling different but related products in the same market. ?? Conglomeration??- Two companies that have no common business areas. METHODS OF VALUATION FOR MERGERS AND ACQUISITIONS Here, I have shown the detailed description of the discounted-cash-flow (DCF) approach and other methods of valuation, such as market multiples of peer firms, book value,liquidation value, replacement cost, market value, and comparable transaction multiples. Discounted-Cash-Flow Method
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Overview The discounted-cash-flow approach in an M&A setting attempts to determine the value of the company (or “enterprise value”) by computing the present value of cash flows over the life of the company. Since a corporation is assumed to have infinite life, the analysis is broken into two parts: a forecast period and a terminal value. In the forecast period, explicit forecasts of free cash flow must be developed that incorporate the economic costs and benefits of the transaction. Ideally, the forecast period should equate with the interval over which the firm enjoys a competitive advantage (i. e. the circumstances where expected returns exceed required returns). In most circumstances, a forecast period of five or ten years is used. Basics of DCF The basics of define the following concepts :free cash flows, terminal value, and the WACC. It is important to realize that these fundamental concepts work equally well when valuing an investment project as they do in an M&A setting. Free cash flows The free cash flows in an M&A analysis should be the expected incremental operating cash flows attributable to the acquisition, before consideration of financing charges (i. e. ,pre-financing cash flows).
Free cash flow equals the sum of NOPAT (net operating profits aftertaxes. ), plus depreciation and noncash charges, less capital investment and less investment in working capital. NOPAT is used to capture the earnings after taxes that are available to all providers of capital: i. e. , NOPAT has no deductions for financing costs. Moreover, since the tax deductibility of interest payments is accounted for in the WACC, such financing tax effects are also excluded from the free cash flow, which can be expressed as: | FCF = NOPAT + Depreciation ” CAPEX ” ? NWC | here , ??? NOPAT is equal to EBIT (1-t) where t is the appropriate marginal (not average) cash tax rate, which should be inclusive of federal, state and local, and foreign jurisdictional taxes. ??? Depreciation is non-cash operating charges including depreciation, depletion, and amortization recognized for tax purposes. ??? CAPEX is capital expenditures for fixed assets. ??? ? NWC is the increase in net working capital defined as current assets less the non-interest bearing current liabilities. The cash-flow forecast should be grounded in a thorough industry and company forecast.
Care should be taken to ensure that the forecast reflects consistency with firm strategy as well as with macroeconomic and industry trends and competitive pressure. The forecast period is normally the years during which the analyst estimates free cash flows that are consistent with creating value. A convenient way to think about value creation is whenever the return on net assets (RONA) exceeds the weighted average cost of capital (WACC). RONA can be divided into an income statement component and a balance sheet component. | RONA = NOPAT/Net Assets | |= NOPAT/Sales ?
Sales/Net Assets | Terminal value A terminal value in the final year of the forecast period is added to reflect the present value of all cash flows occurring thereafter. Since it capitalizes all future cash flows beyond the final year, the terminal value can be a large component of the value of a company, and therefore deserves careful attention. This can be of particular importance when cash flows over the forecast period are close to zero (or even negative) as the result of aggressive investment for growth. A standard estimator of the terminal value (TV) in the final year of the cash flow forecast s the constant growth valuation formula. | | |Terminal Value = FCFSteady State ? (WACC ” g), | where: ??? FCFSteady State- is the steady state expected free cash flow for the year after the final year of the cash flow forecast ??? WACC is the weighted average cost of capital ??? g is the expected constant annual growth rate of FCFSteady State in perpetuity One challenging part of the analysis is to generate a free cash flow for the year after the forecast period that reflects a sustainable or “steady state” cash flow.
Discount rate The discount rate should reflect the weighed average of investors’ opportunity cost(WACC) on comparable investments. The WACC matches the business risk, expected inflation, and currency of the cash flows to be discounted. In order to avoid penalizing the investment opportunity, the WACC also must incorporate the appropriate target weights of financing going forward. Recall that the appropriate rate is a blend of the required rates of return on debt and equity, weighted by the proportion these capital sources make up of the firm’s market value. |WACC = Wd kd(1-t) + We ke |
Where, ??? kd is the required yield on new debt: it’s yield to maturity ??? ke is the cost of equity capital. ??? We,Wd, are target percentages of debt and equity (using market values of debt andequity). ??? t is the marginal tax rate. The costs of debt and equity should be going-forward market rates of return. For debt securities, this is often the yield to maturity that would be demanded on new instruments of the same credit rating and maturity. The cost of equity can be obtained from the Capital AssetPricing Model (CAPM). | Ke = Rf + ? (Rm ‘” Rf), | where: Rf is the expected return on risk-free securities over a time horizon consistent with theinvestment horizon. Most firm valuations are best served by using a long maturity government bond yield. Generally use the 10-year government bond rate. ??? Rm ‘” Rf is the expected market risk premium. This value is commonly estimated as the average historical difference between the returns on common stocks and long-term government bonds. ??? ? is beta, a measure of the systematic risk of a firm’s common stock. The beta of common stock includes compensation for business and financial risk.
OTHER METHODS OF VALUATION OF M Although I have focused on the DCF method, other methods provide useful complementary information in assessing the value of a target. I briefly review some of the most popularly used techniques. 1)Book value ??? May be appropriate for firms with no intangible assets, commodity-type assets valued at market, and stable operations. Some caveats: ??? This method depends on accounting practices that vary across firms. ??? Ignores intangible assets like brand names, patents, technical know-how, and managerial competence. ??? Ignores price appreciation due, for instance, to inflation. Invites disputes about types of liabilities. For instance, is deferred taxes equity or debt? ??? Book value method is backward looking. It ignores the positive or negative operating prospects of the firm and is often a poor proxy for market value. 2)Liquidation value ??? The sale of assets at a point in time. May be appropriate for firms in financial distress, or more generally, for firms whose operating prospects are very cloudy. Requires the skills of a business mortician rather than an operating manager. Some caveats ??? Difficult to get a consensus valuation. Liquidation values tend to be highly appraiser-specific. Key judgment: How finely one might break up the company: Group? Division? Product line? Region? Plant? Machines? ??? Physical condition, not age, will affect values. There can be no substitute for an on-site assessment of a company’s real assets. ??? May ignore valuable intangible assets. 3)Replacement-cost value ??? In the 1970s and early 1980s, during the era of high inflation in the United States, the Securities and Exchange Commission required public corporations to estimate replacement values in their 10-K reports. This is no longer the case making this method less useful for U. S. irms but still is useful for international firms where the requirement continues. ??? But comparisons of replacement costs and stock market values ignore the possible reasons for the disparity: overcapacity, high interest rates, oil shocks, inflation, etc. ??? Replacement cost estimates are not highly reliable, often drawn by simplistic rules of thumb. Estimators themselves (operating managers) frequently dismiss the estimates. 4)Market value of traded securities ??? Most often, this method is used to value the equity of the firm (E) as | stock price ? outstanding shares |
It can also be used to value the enterprise (V) by adding the marketvalue of debt (D) as the | price per bond ? number of bonds outstanding. | ??? Helpful if the stock is actively traded, followed by professional securities analysts, and if the market efficiently impounds all public information about the company and its industry. ??? Rarely do merger negotiations settle at a price below the market price of the target. On average, mergers and tender offers command a 30% to 50% premium over the price one day before the merger announcement. Premiums have been observed to be as high as 100% in some instances.
Often the price increase is attributed to a “control premium. ” The premium will depend on the rarity of the assets sought after and to what extent there are close substitutes for the technology, expertise, or capability in question, the distribution of financial resources between the bidder and target, the egos of the CEOs involved (the hubris hypothesis), or the possibility that the ex ante target price was unduly inflated by market rumors. ??? Less helpful for less well-known companies with thinly or intermittently traded stock. Not available for privately held companies. Ignores private information known only to insiders or acquirers who may see a special economic opportunity in the target company. Remember, the market can efficiently impound only public information. Transaction multiples for comparable deals In an M&A setting, analysts will look to comparable transactions as an additional benchmark against which to assess the target firm. The chief difference between transaction multiples and peer multiples is that the former will reflect a “control premium,” typically 30% to 50%, that is not present in the ordinary trading multiples.
If one is examining the price paid for the target equity, transactions multiples might include the offer price per share ? target book value of equity per share, or offer price per share ? target earnings per share. If one is examining the total consideration paid in recent deals, one can use Enterprise Value? EBIT. Analysts will also look at premiums for comparable transactions by comparing the offer price to the target’s price before the merger announcement at selected dates, such as one or thirty days, before the announcement.
A negotiator might point to premiums in previous deals for similarly situated sellers and demand that shareholders receive “what the market is paying. ” One must look closely, however, at the details of each transaction before agreeing with this premise. How much the target share price will move upon the announcement of a takeover will depend on what the market had anticipated before the announcement. If the share price of the target had been driven up in the days or weeks before the announcement on rumors that a deal was forthcoming, the control premium may appear low.
To adjust for the “anticipation,” one must examine the premium at some point before the market learns of (or begins to anticipate the announcement of) the deal. It could be also that the buyer and seller in previous deals are not in similar situations compared to the current deal. For example, some of the acquirers may have been financial buyers (leveraged buyout (LBO) or private equity firms) while others in the sample were strategic buyers (companies expanding in the same industry as the target. Depending on the synergies involved, the premiums need not be the same for strategic and financial buyers. CONCLUSION The DCF method of valuation is superior for company valuation in an M setting. ??? Not tied to historical accounting values. Is forward looking. ??? Focuses on cash flow, not profits. It reflects noncash charges and investment inflows and outflows. ??? Separates the investment and financing effects into discrete variables. ??? Recognizes the time value of money. ??? Allows private information or special insights to be incorporated explicitly. Allows expected operating strategy to be incorporated explicitly. ??? Embodies the operating costs and benefits of intangible assets. Virtually every number used in valuation is measured with error, either because of flawed methods to describe the past or because of uncertainty about the future. Therefore: ??? No valuation is “right” in any absolute sense. ??? It is appropriate to use several scenarios about the future and even several valuation methods to limit the target’s value.
Adapt to diversity: It may be easier and more accurate to value the divisions or product lines of a target, than to value the whole company. Recognize that different valuation methods may be appropriate for different components. Avoid analysis paralysis: Limit the value quickly. Then if the target still looks attractive try some sensitivity analysis. Beyond the initial buy/no buy decision, the purpose of most valuation analysis is to support negotiators. Knowing value boundaries and conducting sensitivity analysis enhances one’s flexibility to respond to new ideas that may appear at the negotiating table.