Valuation for Mergers & Acquisitions

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Giddy/SIM Valuation for M&A-1

SIM/NYU The Job of the CFO

Prof. Ian Giddy New York University

What’s a Company Worth to Another Company?

l Required Returns YeoYeo HiapHiap SengSeng l Types of Models uBalance sheet models uDividend discount & corporate cash flow models uPrice/Earnings ratios uOption models l Estimating Growth Rates l Application: How These Change with M&A

Framework for Assessing Retructuring Opportunities

Current Market Current market Value Maximum overpricing or restructuring underpricng 1 opportunity

Total Company’s 2 5 restructured DCF value value

Restructuring Financial Framework structure Operating improvements improvements (Eg Increase D/E) 4 3 Potential Potential value with value with internal internal Disposal/ + external Acquisition improvements improvements opportunities

Equity Valuation: From the Balance Sheet

Value of Assets Value of

nBook Liabilities n nLiquidation Book n nReplacement Market Value of Equity

Relative Valuation

l Do valuation ratios make sense? • Price/Earnings (P/E) ratios

q and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples) • Price/Book (P/BV) ratios

q and variants (Tobin's Q) • Price/Sales ratios

l It depends on how they are used -- and what’s behind them!

Discounted Cashflow Valuation: Basis for Approach t =n CFt Value= å t t=1(1+r) uwhere u n = Life of the asset

u CFt = Cashflow in period t u r = Discount rate reflecting the riskiness of the estimated cashflows

Valuing a Firm with DCF: An Illustration

Historical Adjust for Gauge Projected sales Adjust for financial nonrecurring future and operating noncash results aspects growth profits items

Projected free cash flows to the firm (FCFF)

Year 1 Year 2 Year 3 Year 4 Terminal year FCFF FCFF FCFF FCFF FCFF … Stable growth model or P/E comparable Discount to present using weighted average cost of capital (WACC)

Present + cash, - Market Value of value of free securities & value of shareholders cash flows excess assets debt equity

Valuation Example

Fong Industries (Pte) Ltd Singapore Profit & Loss (S$'000) FYE 30 Jun 1994 1995 1996 1997 1998 1999

Turnover 9,651 57,888 125,010 120,323 136,003 134,813

Directors' Fees & Rem 107 249 368 820 961 964 Amortisation 0 269 279 280 35 39 Depreciation 639 1,041 1,277 3,812 4,673 4,494 Interest Expense 227 445 615 1,002 1,078 697 Bad Debts W/O 100 Fixed Assets W/O 4 543 27 FX loss 85 282

Profit b/f Tax 933 1,990 838 1,250 3,774 6,897 Assoc Co (74) 37 (14) 933 1,990 838 1,176 3,811 6,883

Tax 3 96 292 929 178 Profit a/f Tax 930 1,990 742 884 2,882 6,705

Effective Tax Rate 0.32% 0.00% 11.46% 24.83% 24.38% 2.59%

EOI 7,292 (768) (7) (156)

EBITDA 1,799 3,745 108.17% 3,009 -19.65% 6,270 108.37% 9,597 #### 12,113 ISC 792.51% 841.57% 489.27% 625.75% 890.26% 1737.88%

Valuation Example

Fong Industries Growth1 25% for 3 years Growth2 5% thereafter T 1 T 2 T 3 T 4 Tax 25% effective T 1 T 2 T 3 T 4 Revenue 168,516 210,645 263,307 276,472 Revenue 134,813 (S$'000); T0 Revenue 168,516 210,645 263,307 276,472 -Expenses 153,375 191,719 239,648 251,631 Expenses 91.01% of Revenue -Expenses 153,375 191,719 239,648 251,631 -Depreciation 4,533 4,533 4,533 4,533 EBIT 7,580 (S$'000) -Depreciation 4,533 4,533 4,533 4,533 EBIT 10,608 14,394 19,125 20,308 WC 10% of Revenue EBIT 10,608 14,394 19,125 20,308 EBIT(1-t) 7,956 10,795 14,344 15,231 b (unlevered) 1.06 EBIT(1-t) 7,956 10,795 14,344 15,231 +Depreciation 4,533 4,533 4,533 4,533 b (levered) 1.09 +Depreciation 4,533 4,533 4,533 4,533 -CapEx 4,533 4,533 4,533 4,533 -CapEx 4,533 4,533 4,533 4,533 K d 5.50% -Change in WC 3,370 4,213 5,266 1,317 -Change in WC 3,370 4,213 5,266 1,317 MV e 218,993 (S$'000) PERMkt 32.66 FCFF 4,586 6,582 9,078 13,915 FCFF 4,586 6,582 9,078 13,915 MV d 7,379 (S$'000) 187,655 187,655 Combined 226,372 (S$'000) 4,586 6,582 196,733 4,586 6,582 196,733 Firm Value 147,773 Rm 12.00% Firm Value 147,773 Equity Value 140,394 $0.65 Rf 4.00% Equity Value 140,394 $0.65 PERcomputed 20.94 PERcomputed 20.94 K e 12.69% WACC 12.41%

Estimating Future Cash Flows

n Dividends?

n Free cash flows to equity?

n Free cash flows to firm?

The Weighted Average Cost of Capital

Choice Cost 1. 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

l A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever. t =¥ CF Value= å t t t =1(1+r)

l 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: t =N CF t Terminal Value Value = å + t N t =1 (1+r) (1+r)

Dividend Discount Models: General Model

¥ Dt o V = å t t =1 (1+ k)

lV0 = Value of Stock lDt = Dividend lk = required return

Specified Holding Period Model

+ = D1 + D2 ...+ DN PN V 0 1 2 N (1+k) (1+k) (1+k)

l PN = the expected sales price for the stock at time N

l N = the specified number of years the stock is expected to be held

No Growth Model

D V o = k

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

l Preferred Stock

No Growth Model: Example

n Burlington Power & Light n Burlington Power & Light hashas earnings earnings of of $5 $5 per per share share D andand pays pays out out 100% 100% dividend dividend n The required return that n The required return that V o = shareholdersshareholders expect expect is is 15% 15%

n The earnings are not k n The earnings are not expectedexpected to to grow grow but but remain remain steadysteady indefinitely indefinitely

n What’s a BPL share worth? n What’s a BPL share worth? E1 = D1 = $5.00 k = .15

V0 = $5.00 / .15 = $33.33

Constant Growth Model

Do(1+ g) Vo = k - g

lg = constant perpetual growth rate

Constant Growth Model: Example

n Motel 6 has earnings of $5 n Motel 6 has earnings of $5 perper share. share. It It reinvests reinvests 40% 40% andand pays pays out out 60%dividend 60%dividend n The required return that Do(1+ g) n The required return that Vo = shareholdersshareholders expect expect is is 15% 15% n The earnings are expected n The earnings are expected k - g toto grow grow at at 8% 8% per per annum annum

n What’s an M6 share worth? n What’s an M6 share worth?

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

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

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

Estimating Dividend Growth Rates

g = ROE ´ b

l g = growth rate in dividends l ROE = Return on Equity for the firm l b = plowback or retention percentage rate i.e.(1- dividend payout percentage rate)

Or Use Analysts’ Expectations?

Shifting Growth Rate Model

T t (1+g1) DT(1+g2) o o V = D å t + T t=1 (1+k) (k - g2)(1+k)

lg1 = first growth rate

lg2 = second growth rate lT = number of periods of growth at

Shifting Growth Rate Model: Example

n Mindspring n Mindspring payspays dividends dividends $2$2 per per share. share. D0 = $2.00 g1 = 20% g2 = 5% TheThe required required returnreturn that that k = 15% T = 3 D1 = 2.40 shareholdersshareholders D = 2.88 D = 3.46 D = 3.63 expectexpect is is 15% 15% 2 3 4 n The dividends n The dividends areare expected expected to to growgrow at at 20% 20% for for 2 3 3 years and 5% V0 = D1/(1.15) + D2/(1.15) + D3/(1.15) 3 years and 5% thereafterthereafter 3 n What’s a + D4 / (.15 - .05) ( (1.15) n What’s a MindspringMindspring shareshare worth? worth?

V0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40

Stable Growth and Terminal Value

l 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

l 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.

l While companies can maintain high growth rates for extended periods, they will all approach “stable growth” at some point in time.

l 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

l 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: u there is no high growth, in which case the firm is already in stable growth u 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) u 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)

l The assumption of how long high growth will continue will depend upon several factors including: u the size of the firm (larger firm -> shorter high growth periods) u current growth rate (if high -> longer high growth period) u barriers to entry and differential advantages (if high -> longer growth period)

Length of High Growth Period

l 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?

o Earthlink Network

o Biogen

o 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 a Cash Flow Dividends Cashflows to Equity Cashflows to Firm Expected Dividends to Net Income EBIT (1- tax rate) Stockholders - (1- d) (Capital Exp. - Deprec’n) - (Capital Exp. - Deprec’n) - (1- d) Change in Work. Capital - Change in Work. Capital = Free Cash flow to Equity (FCFE) = Free Cash flow to Firm (FCFF) [d = Debt Ratio] & A Discount Rate Cost of Equity Cost of Capital · Basis: The riskier the investment, the greater is the cost of equity. WACC = ke ( E/ (D+E)) · Models: + kd ( D/(D+E)) CAPM: Riskfree Rate + Beta (Risk Premium) kd = Current Borrowing Rate (1-t)

APM: Riskfree Rate + S Betaj (Risk Premiumj): n factors E,D: Mkt Val of Equity and Debt & a growth pattern Stable Growth Two-Stage Growth Three-Stage Growth g g g

| | t High Growth Stable High Growth Transition Stable

The Building Blocks of Valuation

Choose a Cash Flow Dividends Cashflows to Equity Cashflows to Firm Expected Dividends to Net Income EBIT (1- tax rate) Stockholders - (1- d) (Capital Exp. - Deprec’n) - (Capital Exp. - Deprec’n) - (1- d) Change in Work. Capital - Change in Work. Capital = Free Cash flow to Equity (FCFE) = Free Cash flow to Firm (FCFF) [d = Debt Ratio] & A Discount Rate Cost of Equity Cost of Capital Spreadsheet· Basis: The riskier the investment, the greater is the cosexamplet of equity. WACC = ke ( E/ (D+E)) · Models: + kd ( D/(D+E))

CAPM: Riskfree Rate + Beta (Risk Premium) kd = Current Borrowing Rate (1-t)

APM: Riskfree Rate + S Betaj (Risk Premiumj): n factors E,D: Mkt Val of Equity and Debt & a growth pattern Stable Growth Two-Stage Growth Three-Stage Growth g g g

| | t High Growth Stable High Growth Transition Stable

Relative Valuation

l 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

q and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples) • Price/Book (P/BV) ratios

q and variants (Tobin's Q) • Price/Sales ratios

Price Earnings Ratios

l P/E Ratios are a function of two factors uRequired rates of return (k) uExpected growth in dividends

l Uses uRelative valuation uExtensive use in industry

Ratios Do Have Meaning

DPS1 P0 = l Gordon Growth Model: r - g n

l Dividing both sides by the earnings,

P Payout Ratio * (1 + g ) 0 = PE = n EPS 0 r-g n

l Dividing both sides by the book value of equity, P ROE * Payout Ratio * (1 + g ) 0 = PBV = n BV 0 r-g n l If the return on equity is written in terms of the retention ratio and the expected growth rate P ROE - g 0 = PBV = n BV 0 r-gn

l Dividing by the Sales per share,

P Profit Margin * Payout Ratio * (1 + g ) 0 = PS = n Sales 0 r-g n

P/E Ratio: No expected growth

E 1 P 0 = k P 0 1 = E 1 k

l E1 - expected earnings for next year

u E1 is equal to D1 under no growth l k - required rate of return

P/E Ratio with Constant Growth

D1 E1(1- b) P0 = = k - g k - (b ´ ROE)

P0 1- b = E1 k - (b ´ ROE)

Where

l b = retention ratio

l 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

n Quickie Broom Co has earnings of $2.50 per n Quickie Broom Co has earnings of $2.50 per share.share. It It pays pays out out 100%dividend 100%dividend n The required return that shareholders expect n The required return that shareholders expect isis 12.5% 12.5% (based (based on on CAPM CAPM with with Beta Beta of of 1, 1, RF RF = = 7%,7%, Market Market risk risk premium premium 5.5%) 5.5%) n What PE ratio should such a company have? n 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 Or PE = (1 - .60) / (.125 - .6(.15)) = 11.4

PE ratio divided Disney: Relative Valuation by the growth rate

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

Is Disney fairly valued?

l Based upon the PE ratio, is Disney under, over or correctly valued?

o Under Valued

o Over Valued

o Correctly Valued

l Based upon the PEG ratio, is Disney under valued?

o Under Valued

o Over Valued

o Correctly Valued

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

o Higher

o Lower

Relative Valuation Assumptions

l 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?

o The sector itself is, on average, fairly priced

o The earnings of the firms in the group are being measured consistently

o The firms in the group are all of equivalent risk

o The firms in the group are all at the same stage in the growth cycle

o The firms in the group are of equivalent risk and have similar cash flow patterns

o All of the above

Equity Valuation: Application to M&A

Prof. Ian Giddy New 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)

The Gains From an Acquisition

Gains from merger

Synergies Control

Top line Bottom line Financial Business restructuring Restructuring (M&A)

Framework for Assessing Retructuring Opportunities

Current Market Current market Value Maximum overpricing or restructuring underpricng 1 opportunity

Total Company’s 2 5 restructured DCF value value

Equity Valuation in Practice

l Estimating discount rate

l Estimating cash flows l Application to Optika

l Application in M&A: Schirnding-Optika

Optika Optika Growth 5% Tax rate 35% Initial Revenues 3125 COGS 89% WC 10% WACC: Equity Market Value 1300 ReE/(D+E)+RdD/(D+E)Debt Market Value 250 Beta 1 Treasury bond rate 7% Debt spread 1.5% Value: Market risk premium 5.50% FCFF/(WACC-growth rate) T+1 Revenues 3281 CAPM: -COGS 2920 7%+1(5.50%) -Depreciation 74 Equity Value: =EBIT 287 EBIT(1-Tax) 187 Debt cost Firm Value - Debt Value -Change in WC 16 (7%+1.5%)(1-.35) = 2278-250 = 2028 =Free Cash Flow to Firm 171 Cost of Equity (from CAPM) 12.50% Cost of Debt (after tax) 5.53% WACC 11.38% Firm Value 2278

Optika & Schirnding Schirnding-Optika Optika Schirnding Combined Growth 5% 5% 5% Tax rate 35% 35% 35% Initial Revenues 3125 4400 7525 COGS 89% 87.50% WC 10% 10% 10% Equity Market Value 1300 2000 3300 Debt Market Value 250 160 410 Beta 1 1 1 Treasury 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+1 Revenues 3281 4620 7901 -COGS 2920 4043 6963 -Depreciation 74 200 274 =EBIT 287 378 664 EBIT(1-Tax) 187 245 432 -Change in WC 16 22 38 =Free Cash Flow to Firm 171 223 394 Cost 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 Synergy

Schirnding-Optika Optika Schirnding Combined Synergy Growth 5% 5% 5% 5% Tax rate 35% 35% 35% 35% Initial Revenues 3125 4400 7525 7525 COGS 89% 87.50% 86.00% WC 10% 10% 10% 10% Equity Market Value 1300 2000 3300 3300 Debt Market Value 250 160 410 410 Beta 1 1 1 1 Treasury 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+1 Revenues 3281 4620 7901 7901 -COGS 2920 4043 6963 6795 -Depreciation 74 200 274 274 =EBIT 287 378 664 832 EBIT(1-Tax) 187 245 432 541 -Change in WC 16 22 38 38 =Free Cash Flow to Firm 171 223 394 503 Cost 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 7479 Increase 1620 Copyright ©2001 Ian H. Giddy giddy.org Valuation for M&A 47 Giddy/SIM Valuation for M&A-24

Breaking Up is Hard to Do

Implementation

CaseCase Studies:Studies:

nnIntracoIntraco

nnNatsteelNatsteel

Fish and Chips

Intraco's eclectic menu of products and services includes fish and chips: It operates in telecommunications, commodities, foods (such as saltwater fish), engineering, and semiconductors (chips). Its Teledata subsidiary provides telecom services and products and project management. Intraco Trading buys and sells plastics, petrochemicals, and metals. Intraco Foods deals in seafood, dairy products, fruit, and frozen food. The engineering and projects unit has five divisions: electrical, building materials, land transport, marine and port, and environmental engineering. The semiconductor unit distributes such products as DRAMs and AMD microprocessors. The firm has shed its auto unit. NatSteel owns 22% of Intraco.

http://www.intraco.com.sg

Natsteal

Just as a metallurgist mixes metals to produce a strong alloy, NatSteel mixes steelmaking and a variety of other activities to make it one of Singapore's largest industrial groups. NatSteel's range of operations includes electronics, building products (cement and precast concrete), chemicals, engineering products and services, and property development. Its steel division has mini-mills in China, Malaysia, the Philippines, Singapore, and Vietnam. Its electronics division consists of two contract manufacturers. The company has an e-commerce initiative to transform its steel commodities into a value-added service business. NatSteel's operations span 15 countries in Asia, Australia, and Europe.

http://www.natsteel.com.sg

The Gains From an Acquisition

Gains from merger

Synergies Control

Top line Bottom line Financial Business restructuring Restructuring (M&A)

giddy.org

Ian Giddy NYU Stern School of Business Tel 212-998-0332 Fax 917-463-7629 [email protected] http://giddy.org