Applying Relative, Asset Oriented, and Real Option Valuation Methods to Mergers and Acquisitions

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Applying Relative, Asset Oriented, and Real
Option Valuation Methods to Mergers and
Acquisitions
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You earn a living by what you get, but you build
a life by what you give. Winston Churchill
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Cross-Border Transactions
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Learning Objectives

• Primary learning objective To provide students
  with knowledge of alternatives to discounted cash
  flow valuation methods, including
• Market Approach
• Comparable companies
• Comparable transactions
• Same industry or comparable industry
• Asset oriented approach
• Tangible book value
• Liquidation value
• Break-up value
• Cost approach
• Weighted average method
• Secondary learning objective Enable students to
  understand how real options apply to MAs

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Applying Market-Based (Relative Valuation)
Methods1

• MVT (MVC / IC) x IT
• Where
• MVT Market value of target company
• MVC Market value of the comparable
  company C
• IC Measure of value for comparable
  company C
• IT Measure of value for company T
• (MVC/IC) Market value multiple for the
  comparable
• company
• 1Comparable companies may include those with
  profitability, risk, and growth characteristics
  similar to the target firm.

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Market-Based Methods Comparable Company Example
Exhibit 8-1. Valuing Repsol YPF Using Comparable Integrated Oil Companies Exhibit 8-1. Valuing Repsol YPF Using Comparable Integrated Oil Companies Exhibit 8-1. Valuing Repsol YPF Using Comparable Integrated Oil Companies Exhibit 8-1. Valuing Repsol YPF Using Comparable Integrated Oil Companies Exhibit 8-1. Valuing Repsol YPF Using Comparable Integrated Oil Companies Exhibit 8-1. Valuing Repsol YPF Using Comparable Integrated Oil Companies
Target Valuation Based on Following Multiples (MVC/VIC) Target Valuation Based on Following Multiples (MVC/VIC) Target Valuation Based on Following Multiples (MVC/VIC) Target Valuation Based on Following Multiples (MVC/VIC) Target Valuation Based on Following Multiples (MVC/VIC)
Comparable Company Trailing P/E1 Forward P/E2 Price/Sales Price/Book Average
Col. 1 Col. 2 Col. 3 Col. 4 Col. 1-4
Exxon Mobil Corp (XOM) 11.25 8.73 1.17 3.71
British Petroleum (BP) 9.18 7.68 0.69 2.17
Chevron Corp (CVX) 10.79 8.05 0.91 2.54
Royal Dutch Shell (RDS-B) 7.36 8.35 0.61 1.86
ConocoPhillips (COP) 11.92 6.89 0.77 1.59
Total SA (TOT) 8.75 8.73 0.80 2.53
Eni SpA (E) 3.17 7.91 0.36 0.81
PetroChina Co. (PTR) 11.96 10.75 1.75 2.10
Average Multiple (MVC/VIC) Times 9.30 8.39 0.88 2.16
Repsol YPF Projections (VIT)3 4.38 3.27 92.66 26.49
Equals Estimated Mkt. Value of Target3 40.72 27.42 81.77 57.32 51.81
1Trailing 52 week average. 2Projected 52 week average. 3Billions of Dollars. Key Points 1. Firm valuation differs significantly depending on valuation multiple used. 2. Valuation estimates require addition of a purchase price premium. 1Trailing 52 week average. 2Projected 52 week average. 3Billions of Dollars. Key Points 1. Firm valuation differs significantly depending on valuation multiple used. 2. Valuation estimates require addition of a purchase price premium. 1Trailing 52 week average. 2Projected 52 week average. 3Billions of Dollars. Key Points 1. Firm valuation differs significantly depending on valuation multiple used. 2. Valuation estimates require addition of a purchase price premium. 1Trailing 52 week average. 2Projected 52 week average. 3Billions of Dollars. Key Points 1. Firm valuation differs significantly depending on valuation multiple used. 2. Valuation estimates require addition of a purchase price premium. 1Trailing 52 week average. 2Projected 52 week average. 3Billions of Dollars. Key Points 1. Firm valuation differs significantly depending on valuation multiple used. 2. Valuation estimates require addition of a purchase price premium. 1Trailing 52 week average. 2Projected 52 week average. 3Billions of Dollars. Key Points 1. Firm valuation differs significantly depending on valuation multiple used. 2. Valuation estimates require addition of a purchase price premium.
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Market-Based MethodsRecent Transactions Method1

• Calculation similar to comparable companies
  method, except multiples used to estimate
  targets value based on purchase prices of recent
  transactions of comparable companies.
• MVT (MVRT / IRT) x IT
• Where
• MVT Market value of target company
  T
• MVRT Market value of the recently
  acquired comparable company RT
• IRT Measure of value for recently
  acquired comparable company RT
• IT Measure of value for target
  company T
• (MVRT/IRT) Market value multiple for the
  recently acquired comparable company RT
• Most accurate method whenever the transaction is
  truly comparable and very recent.
• Major limitation is that truly comparable recent
  transactions are rare.
• Valuations based on this method already include a
  purchase price premium
• 1Also called precedent method.

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Market-Based MethodsSame or Comparable Industry
Method

• Multiply targets earnings or revenues by market
  value to earnings or revenue ratios for the
  average firm in targets industry or a comparable
  industry.
• MVT (MVAF / IAF) x IT
• Where
• MVT Market value of target firm
• MVAF Market value of average firm in
  target firms or comparable industry
• IAF Measure of value for average
  firm in target firms or comparable Industry
• IT Measure of value for
  company T
• (MVAF/IAF) Market value multiple for the
  average firm in target firms or comparable
• industry
• Primary advantage is the ease of use and
  availability of data.
• Disadvantages include presumption industry
  multiples are actually comparable and analysts
  projections are unbiased.
• Requires addition of purchase price premium

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PEG Ratio

• Used to adjust relative valuation methods for
  differences in growth rates among comparable
  firms.
• Helpful in determining which of a number of
  different firms in same industry exhibiting
  different growth rates may be the most
  attractive.
• (MVT/VIT) A and
• 
  VITGR
• 
  MVT A x VITGR x VIT
• Where A Market price to value indicator
  relative to the growth rate of
• value indicator (e.g.,
  (P/E)/ EPS growth rate)
• MVT Market value of target
• VIT Value indicator for target
  (e.g., EPS)1
• VITGR Projected growth rate in value
  indicator (e.g., EPS)
• Firms whose PEG ratios gt 1 considered overvalued
  PEG ratios lt 1 considered undervalued
• 1Valid for VITGR gt 0. For VITGR 0 or lt 0, firm
  value will not change or will decline.

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Applying the PEG Ratio An analyst is asked to
determine whether Basic Energy Service (BAS) or
Composite Production Services (CPS) is more
attractive as an acquisition target. Both firms
provide engineering, construction, and specialty
services to the oil, gas, refinery, and
petrochemical industries. BES and CPS have
projected annual earnings per share growth rates
of 15 percent and 9 percent, respectively. BES
and CPS current earnings per share are 2.05 and
3.15, respectively. The current share prices as
of June 25, 2008 for BAS is 31.48 and for CPX is
26. The industry average price-to-earnings ratio
and growth rate are 12.4 and 11 percent,
respectively. Based on this information, which
firm is a more attractive takeover target as of
the point in time the firms are being compared?
Industry average PEG ratio1 12.4/.11 112.73
BES Implied share price 112.73 x .15 x 2.05
34.66 CPX Implied share price 112.73 x .09
x 3.15 31.96 Answer The difference between
the implied and actual share prices for BES and
CPX is 3.18 (i.e., 34.66 - 31.48) and 5.96
(31.96 - 26.00), respectively. CPX is more
undervalued than BES at that moment in time and
therefore is the more attractive takeover target.
1Solving MVT A x VITGR x VIT using an
individual firms PEG ratio provides the firms
current share price in period T, since this
formula is an identity. An industry average PEG
ratio may be used to provide an estimate of the
firms intrinsic value. This implicitly assumes
that the target firm and the average firm in the
industry exhibit the same relationship between
price-to-earnings ratios and earnings growth
rates.
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Asset-Based MethodsTangible Book Value

• Tangible book value (TBV) (total assets - total
  liabilities - goodwill)
• MVT (MVC /
  ICTBV) x ITTBV
• Where
• MVT Market value of target
  company
• MVC Market value of the comparable
  company C
• ICTBV Tangible book value for
  comparable company C
• ITTBV Tangible book value for
  target company
• (MVC/ICTBV) Market value multiple for the
  comparable company
• Often used for valuing
• Financial services firms where tangible book
  value is primarily cash or liquid assets
• Distribution firms where current assets
  constitute a large percentage of total assets

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Valuing Companies Using Asset Based Methods
Ingram Micro distributes information technology products worldwide. The firms share price on 8/21/08 was 19.30. Projected 5-year annual net income growth is 9.5 and the firms beta is .89. Shareholders equity is 3.4 billion and goodwill is .7 billion. Ingram has 172 million (.172 billion) shares outstanding. The following firms represent Ingrams primary competitors. Ingram Micro distributes information technology products worldwide. The firms share price on 8/21/08 was 19.30. Projected 5-year annual net income growth is 9.5 and the firms beta is .89. Shareholders equity is 3.4 billion and goodwill is .7 billion. Ingram has 172 million (.172 billion) shares outstanding. The following firms represent Ingrams primary competitors. Ingram Micro distributes information technology products worldwide. The firms share price on 8/21/08 was 19.30. Projected 5-year annual net income growth is 9.5 and the firms beta is .89. Shareholders equity is 3.4 billion and goodwill is .7 billion. Ingram has 172 million (.172 billion) shares outstanding. The following firms represent Ingrams primary competitors. Ingram Micro distributes information technology products worldwide. The firms share price on 8/21/08 was 19.30. Projected 5-year annual net income growth is 9.5 and the firms beta is .89. Shareholders equity is 3.4 billion and goodwill is .7 billion. Ingram has 172 million (.172 billion) shares outstanding. The following firms represent Ingrams primary competitors.
Market Value/ Tangible Book Value Beta Projected 5-Year Net Income Growth Rate ()
Tech Data .91 .90 11.6
Synnex Corporation .70 .40 6.9
Avnet 1.01 1.09 12.1
Arrow .93 .97 13.2
Based on this information, what is Ingrams tangible book value per share (VIT)? What is the appropriate industry average market value to tangible book value ratio (MVIND/VIIND)? Estimate the implied market value per share for Ingram (MVT) using tangible book value as a value indicator. Based on this analysis, is Ingram under-or-overvalued compared to it 8/21/08 share price? Based on this information, what is Ingrams tangible book value per share (VIT)? What is the appropriate industry average market value to tangible book value ratio (MVIND/VIIND)? Estimate the implied market value per share for Ingram (MVT) using tangible book value as a value indicator. Based on this analysis, is Ingram under-or-overvalued compared to it 8/21/08 share price? Based on this information, what is Ingrams tangible book value per share (VIT)? What is the appropriate industry average market value to tangible book value ratio (MVIND/VIIND)? Estimate the implied market value per share for Ingram (MVT) using tangible book value as a value indicator. Based on this analysis, is Ingram under-or-overvalued compared to it 8/21/08 share price? Based on this information, what is Ingrams tangible book value per share (VIT)? What is the appropriate industry average market value to tangible book value ratio (MVIND/VIIND)? Estimate the implied market value per share for Ingram (MVT) using tangible book value as a value indicator. Based on this analysis, is Ingram under-or-overvalued compared to it 8/21/08 share price?
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Solution to Ingram Problem

• Ingrams net tangible book value per share (VIT)
  (3.4 -.7)/.172 15.70
• Based on risk as measured by the firm beta and
  the 5-year projected earnings growth rate, Synnex
  is believed to exhibit significantly different
  risk and growth characteristics and is excluded
  from the calculation of the industry average
  market value to tangible book value ratio.
  Therefore, the appropriate industry average ratio
  is as follows
• MVIND/VIIND .95 i.e., (.911.01.93)/3
• Ingrams implied value per share MVT
  (MVIND/VIIND) x VIT .95 x 15.70 14.92
• Based on the implied value per share, Ingram was
  over-valued on 8/21/08 when its actual share
  price was 19.30

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Asset-Based Methods Liquidation Method

• Value assets as if sold in an orderly fashion
  (e.g., 9-12 months) and deduct value of
  liabilities and expenses associated with asset
  disposition.
• While varies with industry,
• Receivables often sold for 80-90 of book value
• Inventories might realize 80-90 of book book
  value depending on degree of obsolescence and
  condition
• Equipment values vary widely depending on age and
  condition and purpose (e.g., special purpose)
• Book value of land may understate market value
• Prepaid assets such as insurance can be
  liquidated with a portion of the premium
  recovered.

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Asset-Based Method Break-Up Value

• Target viewed as series of independent operating
  units, whose income, cash flow, and balance sheet
  statements reflect intra-company sales,
  fully-allocated costs, and operating liabilities
  specific to each unit
• After-tax cash flows are valued using
  market-based multiples or discounted cash flows
  analysis to determine operating units estimated
  enterprise value
• The units equity value is determined by
  deducting operating/non-operating liabilities
  from estimated enterprise value
• Aggregate equity value of the business is
  determined by summing equity value of each
  operating unit less unallocated liabilities held
  at corporate level and break-up costs

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Replacement Cost Method

• All target operating assets are assigned a value
  based on what it would cost to replace them.
• Each asset is treated as if no additional value
  is created by operating the assets as part of a
  going concern.
• Each assets value is summed to determine the
  aggregate value of the business.
• This approach is limited if the firm is highly
  profitable (suggesting a high going concern
  value) or if many of the firms assets are
  intangible.

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Weighted Average Valuation Method

• An analyst has estimated the value of a company
  using multiple valuation methodologies. The
  discounted cash flow value is 220 million,
  comparable transactions value is 234 million,
  the P/E-based value is 224 million and the
  liquidation value is 150 million. The analyst
  has greater confidence in certain methodologies
  than others. Estimate the weighted average value
  of the firm using all valuation methodologies and
  the weights or relative importance the analyst
  gives to each methodology.

Estimated Value (M) Relative Weight Weighted Avg. (M)
220 .30 66.0
234 .40 93.6
224 .20 44.8
150 .10 15.0
1.00 219.4
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Real Options as Applied to MAs

• Real options refer to managements ability to
  adopt and later revise corporate investment
  decisions (e.g., acquisitions)
• Options to expand (i.e., accelerate investment)
• Acquirer accelerates investment in target after
  acquisition completed due to better than
  anticipated performance of the target
• Options to delay (i.e., postpone timing of
  initial investment)
• Acquirer delays completion of acquisition until a
  patent pending receives approval
• Options to abandon (i.e., divest or liquidate
  initial investment)
• Acquirer divests target firm due to
  underperformance and recovers a portion of its
  initial investment

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Alternative Real Option Valuation Methods

• Develop a decision tree for which the NPV of each
  branch represents the value of alternative real
  options. The options value is equal to
  difference between the NPV including the real
  option and the NPV without the real option.
• Treat the real options as financial options and
  value using the Black-Scholes method.
• Option to expand or delay are valued as call
  options and added to the NPV of the investment
  without the option.
• Option to abandon is valued as a put option and
  added to the NPV of the investment without the
  option.
• Key Points Total NPV NPV Without Option
  Option Value and
• Option Value Total NPV NPV
  Without Option

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Microsoft Real Options Decision Tree in Attempted
Takeover of Yahoo
Option to expand contingent on successful Integra
tion of Yahoo MSN
Purchase Yahoo online search only. Buy
Remaining businesses later.
Enter long-term search Partnership with option to
buy
Base Case Microsoft Offers To Buy All Yahoo
Shares
Option to postpone contingent on Yahoos
rejection of offer
Offer revised price for all of Yahoo if
circumstances change
Spin off combined Yahoo and MSN to Microsoft
shareholders
Option to abandon contingent on failure to
integrate Yahoo MSN
Divest combined Yahoo MSN. Use proceeds to pay
dividend or buy back stock.
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Microsoft Yahoo Transaction Outcome

• 2008 offer price for all of Yahoo 38 per share
• Offer rejected by Jerry Yang (founder) and board
  of directors
• Microsoft withdraws offer and Yahoo share price
  drops to 16 per share
• Jerry Yang later fired
• Microsoft and Yahoo agree to online search
  partnership in 2010 in which MSN and Yahoo
  combine search businesses

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Things to Remember

• Alternatives to discounted cash flow analysis
  include the following
• Market based methods
• Comparable companies
• Recent transactions
• Same or comparable industries
• Asset based methods
• Tangible book value
• Liquidation value
• Break-up value
• Replacement cost method
• Weighted average method
• Firm value must be adjusted for both
  non-operating assets and liabilities.
• Real options should be considered in MA
  valuation when clearly identifiable and when
  would add significantly to investments value