Chapter 8
Applying Relative, Asset-Oriented, and Real-Option Valuation Methods to Mergers and Acquisitions
Most people are about as happy as they make up their minds to be.
—Abraham Lincoln
Inside M&A: a real-options perspective on microsoft's dealings with Yahoo!
In a bold move to transform two relatively weak online search businesses into a competitor capable of challenging market leader Google, Microsoft proposed to buy Yahoo! for $44.6 billion on February 2, 2008. At $31 per share in cash and stock, the offer represented a 62% premium over Yahoo!'s prior day closing price. Despite boosting its bid to $33 per share to offset a decline in the value of Microsoft's share price following the initial offer, Microsoft was rebuffed by Yahoo!'s board and management. In early May of 2008, Microsoft withdrew its bid to buy the entire firm and substituted an offer to acquire the search business only. Incensed at Yahoo!'s refusal to accept the Microsoft bid, activist shareholder Carl Icahn initiated an unsuccessful proxy fight to replace the Yahoo! board. Throughout this entire melodrama, critics continued to ask how Microsoft could justify an offer valued at $44.6 billion when the market prior to the announcement had valued Yahoo! at only $27.5 billion.
Microsoft could have continued to slug it out with Yahoo! and Google as it had been for the last five years, but this would have given Google more time to consolidate its leadership position. Despite having spent billions of dollars on Microsoft's online service (Microsoft Network, or MSN) in recent years, the business remains a money loser (with losses exceeding one-half billion dollars in 2007). Furthermore, MSN accounted for only 5% of the firm's total revenue at that time.
Microsoft argued that its share of the online Internet search (i.e., ads appearing with search results) and display (i.e., website banner ads) advertising markets would be dramatically increased by combining Yahoo! with MSN. Yahoo! also is the leading consumer e-mail service. Anticipated cost savings from combining the two businesses were expected to reach $1 billion annually. Longer term, Microsoft expected to bundle search and advertising capabilities into the Windows operating system to increase the usage of the combined firms' online services by offering compatible new products and enhanced search capabilities.
The two firms have very different cultures. The iconic Silicon Valley–based Yahoo! often is characterized as a company with a freewheeling, fun-loving culture, potentially incompatible with Microsoft's more structured and disciplined environment. Melding or eliminating overlapping businesses represents a potentially mind-numbing effort given the diversity and complexity of the numerous sites available. To achieve the projected cost savings, Microsoft would have to choose which of the businesses and technologies would survive. Moreover, the software driving all of these sites and services is largely incompatible.
As an independent, or stand-alone, business, the market valued Yahoo! at approximately $17 billion less than Microsoft's valuation. Microsoft was valuing Yahoo! based on its intrinsic stand-alone value plus perceived synergy resulting from combining Yahoo! and MSN. Standard discounted-cash-flow analysis assumes implicitly that once Microsoft makes an investment decision, it cannot change its mind. In reality, once an investment decision is made, management often has a number of opportunities to make future decisions based on the outcome of things that are currently uncertain. These opportunities, or real options, include the decision to expand (i.e., accelerate investment at a later date), delay the initial investment, or abandon an investment. With respect to Microsoft's effort to acquire Yahoo!, the major uncertainties dealt with the actual timing of an acquisition and whether the two businesses could be integrated successfully. For Microsoft's attempted takeover of Yahoo!, such options included the following:
Base case. Buy 100% of Yahoo! immediately.
Option to expand. If Yahoo! accepts the bid, accelerate investment in new products and services contingent on the successful integration of Yahoo! and MSN.
Option to delay. (1) Temporarily walk away, keeping open the possibility of returning for 100% of Yahoo! if circumstances change; (2) offer to buy only the search business with the intent of purchasing the remainder of Yahoo! at a later date; or (3) enter into a search partnership, with an option to buy at a later date.
Option to abandon. If Yahoo! accepts the bid, spin off or divest combined Yahoo!/MSN if integration is unsuccessful.
The decision tree in Figure 8.1 illustrates the range of real options (albeit an incomplete list) available to the Microsoft board at the time of its offer. Each branch of the tree represents a specific option. The decision tree framework is helpful in depicting the significant flexibility that senior management often has in changing an existing investment decision at some point in the future.
Figure 8.1 Microsoft real-options decision tree.
With neither party making headway against Google, Microsoft again approached Yahoo! in mid-2009, which resulted in an announcement in early 2010 of an Internet search agreement between the two firms. Yahoo! transferred control of its Internet search technology to Microsoft in an attempt to boost its sagging profits. Microsoft is relying on a ten-year arrangement with Yahoo! to help counter the dominance of Google in the Internet search market. Both firms hope to be able to attract more advertising dollars paid by firms willing to pay for links on the firms' sites. (See Chapter 14's Inside M&A case study for more details about this partnership.)
Chapter overview
Chapter 7 discussed in detail how DCF analysis is applied to M&A valuation. This chapter addresses alternative methods of valuation. These methods include relative-valuation (i.e., market-based) methods, asset-oriented methods, real-options analysis (i.e., contingent claims), and replacement cost. Relative-valuation methods include comparable company, comparable transactions, comparable industry techniques, and value-driver-based valuation. Asset-oriented methods include tangible book value and liquidation- or breakup-valuation techniques.
The chapter discusses in detail how to look at M&A valuation in the context of real options. This involves identifying preclosing and postclosing strategic and tactical alternatives and associated risks available to M&A participants. Real-options valuation is illustrated both in the context of a decision tree framework and as call and put options, when the assets underlying the option exhibit the characteristics of financial options. A weighted-average valuation approach, which attempts to incorporate the analyst's relative confidence in the various valuation methods, also is discussed. The chapter concludes with a summary of the strengths and weaknesses of alternative valuation methods (including discounted cash flow) and when it is appropriate to apply each methodology.
A review of this chapter (including additional practice problems with solutions) is available in the file folder entitled “Student Study Guide” on the companion site to this book (www.elsevierdirect.com/companions/9780123854858). The companion site also contains a Learning Interactions Library, which gives students the opportunity to test their knowledge of this chapter in a “real-time” environment.
Applying relative-valuation (market-based) methods
Relative valuation involves valuing assets based on how similar assets are valued in the marketplace. Relative-valuation methods assume a firm's market value can be approximated by a value indicator for comparable companies, comparable transactions, or comparable industry averages. Value indicators could include the firm's earnings, operating cash flow, EBITDA (i.e., earnings before interest and taxes, depreciation, and amortization), sales, and book value. This approach often is described as market based, since it reflects the amounts investors are willing to pay for each dollar of earnings, cash flow, sales, or book value at a moment in time. As such, it reflects theoretically the collective wisdom of investors in the marketplace. Because of the requirement for positive current or near-term earnings or cash flow, this approach is meaningful only for companies with a positive, stable earnings or cash-flow stream.
If comparable companies are available, the market value of a target firm T (MV T ) can be estimated by solving the following equation:
(8.1)
where
MV C = market value of the comparable company C
VI C = value indicator for the comparable company C
VI T = value indicator for firm T
(MV C /VI C ) = market value multiple for the comparable company
For example, if the P/E ratio for the comparable firm is equal to 10 (MV C /VI C ) and the after-tax earnings of the target firm are $2 million (VI T ), the market value of the target firm at that moment in time is $20 million (MV T ). Relative-value methods are used widely for three reasons. First, such methods are relatively simple to calculate and require far fewer assumptions than discounted-cash-flow techniques. Second, relative valuation is easier to explain than are DCF methods. Finally, the use of market-based techniques is more likely to reflect current market demand and supply conditions. The relationship expressed in Eq. (8.1) can be used to estimate the value of the target firm in all of the relative-valuation and asset-oriented methods discussed in this chapter.
The analyst must be careful to follow certain guidelines in applying relative-valuation methods. First, when using multiples (i.e., MV C /VI C ), it is critical to ensure that the multiple is defined in the same way for all comparable firms. For example, in using a price-to-earnings ratio, earnings may be defined as trailing (i.e., prior), current, or projected. Whichever way earnings are defined, the definition must be applied consistently to all firms in the sample. Also, the numerator and the denominator of the multiple must be defined in the same way. If the numerator in the price-to-earnings ratio is defined as price per share, the denominator also must be calculated as earnings per share. Second, the analyst must examine the distribution of the multiples of the firms being compared and eliminate outliers. Outliers are those whose values are substantially different from others in the sample. Failure to do so can distort the average or median of the sample.1
The Comparable Companies Method
Applying the comparable companies approach requires that the analyst identify companies that are substantially similar to the target firm. Generally speaking, a comparable firm is one whose profitability, potential growth rate in earnings or cash flows, and perceived risk are similar to those of the firm to be valued. By defining comparable companies broadly, it is possible to utilize firms in other industries. As such, a computer hardware manufacturer can be compared to a telecommunications firm as long as they are comparable in terms of profitability, growth, and risk. Consequently, if the firm to be valued has a 15% return on equity (i.e., profitability),2 expected earnings or cash-flow growth rates of 10% annually (i.e., growth), and a beta of 1.3 or debt to equity ratio of 1 (i.e., risk), the analyst must find a firm with similar characteristics in either the same industry or another industry. In practice, analysts often look for comparable firms in the same industry and that are similar in terms of such things as markets served, product offering, degree of leverage, and size.3
To determine if the firms you have selected are truly comparable, estimate the correlation between the operating income or revenue of the firm to be valued and the comparable firms. If the correlation is positive and high, the firms are comparable. Similarly, if the firm has multiple product lines, collect comparable firms for each product line and estimate the degree of correlation.
Even when companies appear to be substantially similar, there are likely to be significant differences in these data at any one moment in time. These differences may result from investor overreaction to one-time events. For example, the announcement of a pending acquisition may boost the share prices of competitors as investors anticipate takeover bids for these firms. The impact of such events abates with the passage of time. Consequently, comparisons made at different times can provide distinctly different results. By taking an average of multiples over six months or one year, these differences may be minimized. Note that valuations derived using the comparable companies method do not include a purchase price premium.
Table 8.1 illustrates how to apply the comparable companies method to value Spanish oil company Repsol YPF. Repsol is a geographically diversified integrated oil and gas firm engaged in all aspects of the petroleum business, including exploration, development, and production of crude oil and natural gas; petroleum refining; petrochemical production; and marketing of petroleum products. Repsol has economic and political risks and growth characteristics similar to other globally diversified integrated oil and gas companies. The estimated value of Repsol based on the comparable companies method is $51.81 billion versus its actual June 25, 2008, market capitalization of $49.83 billion.
Table 8.1. Valuing Repsol YPF Using Comparable Integrated Oil Companies
a Trailing 52-week averages.
b Projected 52-week averages.
c Billions of dollars.
The analyst needs to be mindful of changes in fundamentals that can affect multiples. These fundamentals include a firm's ability to generate and grow earnings and cash flow through reinvestment in its operations, as well as the risk associated with the firm's earnings and cash flows. Since multiples are affected by each of these variables, changes in the variables affect them. Firms with lower earnings and cash-flow generation potential, lower growth prospects, and higher risk should trade at multiples less than firms with higher earnings and cash-flow generation capability, higher growth prospects, and less risk. Consequently, the analyst needs to understand why one firm's multiple is less than a comparable firm's before concluding that it is under- or overvalued. For example, a firm with a P/E of 10 may not be more expensive than a comparable firm with a P/E of 8 if the former's growth prospects, profitability, and rate at which profits are reinvested in the firm are higher than the latter firm's.
Table 8.2 summarizes the relationships between various multiples and their underlying determinants. The word positive or negative in parentheses next to the factors influencing the multiples indicates the direction of causality. For example, assuming nothing else is changing, price-to-earnings ratios should increase as expected earnings increase and decrease as dividend payout ratios rise, reflecting a lower rate of reinvestment of earnings in the firm.
Table 8.2. Factors Influencing Valuation Multiples
| Multiple | Factor |
| Price-to-Earnings Ratio | Earnings Growth Rate (positive) Payout Ratio (negative)a |
| Price-to-Book Ratio | Return on Equity (positive) Payout Ratio (negative) Earnings Growth Rate (positive) |
| Price-to-Revenue Ratio | Net Profit Margin (positive) Payout Ratio (negative) Earnings Growth Rate (positive) |
| Enterprise Value Multiples | Cash-Flow Growth Rate (positive) |
a Payout ratios refer to dividends as a percent of earnings available for common equity. One minus the payout ratio equals the rate at which a firm is retaining earnings for reinvestment. Therefore, increasing payout ratios indicate a lower firm reinvestment rate.
Recent Comparable Transactions Method
The comparable transactions approach is conceptually similar to the comparable companies approach. This valuation technique also is referred to as the precedent transactions method. The multiples used to estimate the value of the target are based on purchase prices of comparable companies that recently were acquired. Price-to-earnings, sales, cash-flow, EBITDA, and book-value ratios are calculated using the purchase price for the recent comparable transaction. Earnings, sales, cash-flow, EBITDA, and book value for the target subsequently are multiplied by these ratios to obtain an estimate of the market value of the target company. The estimated value of the target firm obtained using recent comparable transactions already reflects a purchase price premium, unlike the comparable companies approach to valuation. The obvious limitation to the comparable transactions method is the difficulty in finding truly comparable, recent transactions. Note that comparable recent transactions can be found in other industries as long as they are similar to the target firm in terms of profitability, expected earnings, and cash flow; growth; and perceived risk. Table 8.1 could be used to illustrate how the recent transaction valuation method may be applied simply by replacing the data in the column headed “Comparable Company” with data for “Recent Comparable Transactions.”
Same or Comparable Industry Method
Using this approach, the target company's net income, revenue, cash-flow, EBITDA, and book value are multiplied by the ratio of the market value of shareholders' equity to net income, revenue, cash-flow, EBITDA, and book value for the average company in the target firm's industry or a comparable industry (see Exhibit 8.1). Such information can be obtained from Standard & Poor's, Value Line, Moody's, Dun & Bradstreet, and Wall Street analysts. The primary advantage of this technique is the ease of use. Disadvantages include the presumption that industry multiples are actually comparable. The use of the industry average may overlook the fact that companies, even in the same industry, can have drastically different expected growth rates, returns on invested capital, and debt-to-total capital ratios.
Valuations Based on Projections May Be Superior to Those Using Historical Data
An analyst using industry or comparable company multiples needs to decide whether or not to use multiples based on current or projected earnings or cash flows or some other measure of value. While projections based on Wall Street analysts' forecasts may not be unbiased, empirical evidence suggests that forecasts of earnings and other value indicators are better predictors of a firm's value than value indicators based on historical data.4
Earnings Show Better Short-Run Correlation with Stock Returns Than Cash Flow
Considerable attention has been paid to whether cash flow, earnings, or dividends are better predictors of a firm's value.5 Studies suggest that cash flows and earnings are highly positively correlated with stock returns over long periods, such as five-year intervals. However, for shorter time periods, earnings show a stronger correlation with stock
Exhibit 8.1 Valuing a Target Company Using the Same or Comparable Industries Method
As of June 25, 2008, Repsol YPF, a Spanish integrated oil and gas producer, had projected earnings per share for the coming year of $3.27 (see Table 8.1). The industry average price-to-earnings ratio at that time for integrated oil and gas companies was 12.4. Estimate the firm's price per share (see Eq. (8.1)).
(8.1)
where
MV T = market value per share of the target company
MVIND/VIIND = market value per share of the average firm in the industry divided by a value indicator for that average firm in the industry (e.g., industry average price-to-earnings ratio)
VI T = value indicator for the target firm (e.g., projected earnings per share)
returns than cash flows.6 As a practical matter, cash flow is more often used for valuation than earnings or dividends simply because firms often do not pay dividends or generate profits for a significant period.
Enterprise Value to EBITDA Method
In recent years, analysts have increasingly used the relationship between enterprise value to earnings before interest and taxes, depreciation, and amortization to value firms. Note that enterprise value can be defined in terms of either the asset or the liability side of the balance sheet. Recall that in Chapter 7 enterprise value was discussed from the perspective of the asset or “left-hand” side of the balance sheet as the present value of free cash flow to the firm (i.e., cash flows generated from operating assets and liabilities available for lenders and common and preferred shareholders). Thus defined, enterprise value was adjusted for the value of nonoperating assets and liabilities to estimate the value of common equity. In this chapter, enterprise value is viewed from the perspective of the liability or “right-hand” side of the balance sheet.
The enterprise value to EBITDA multiple relates the total market value of the firm from the perspective of the liability side of the balance sheet (i.e., long-term debt plus preferred and common equity), excluding cash, to EBITDA. In practice, other long-term liabilities often are ignored and cash is assumed to be equal to cash and short-term marketable securities on the balance sheet. Ignoring other long-term liabilities such as the firm's pension and healthcare obligations only makes sense if they are fully funded.
In constructing the enterprise value, the market value of the firm's common equity value (MVFCFE) is added to the market value of the firm's long-term debt (MV D ) and the market value of preferred stock (MVPF). Cash and short-term marketable securities are deducted from the enterprise value of the firm, since interest income from such cash is not counted in the calculation of EBITDA. Consequently, the inclusion of cash would overstate the enterprise value to EBITDA multiple. The enterprise value (EV) to EBITDA method is commonly expressed as follows:
(8.2)
where (MV D – Cash) is often referred to as net debt.
The enterprise value to EBITDA method is useful because more firms are likely to have negative earnings rather than negative earnings before interest and taxes, depreciation, and amortization. Consequently, relative-valuation methods are more often applicable when EBITDA is used as the value indicator. Furthermore, net or operating income can be significantly affected by the way the firm chooses to calculate depreciation (e.g., straight line versus accelerated). Such problems do not arise if the analyst uses a value indicator such as EBITDA that is estimated before deducting depreciation and amortization expense. Finally, the multiple can be compared more readily among firms exhibiting different levels of leverage than for other measures of earnings, since the numerator represents the total value of the firm irrespective of its distribution between debt and equity, and the denominator measures earnings before interest.
A major shortcoming of EBITDA as a value indicator is that it provides a good estimate of the firm's assets already in place but ignores the impact of new investment on future cash flows. This is not a problem as long as the firm is not growing and, as such, will not be experiencing changes in working capital and increased maintenance investment. Despite this shortcoming, EBITDA is more often used than a multiple based on free cash flow to the firm (FCFF), since FCFF is frequently negative due to changes in working capital and the fact that capital spending often exceeds internally generated funds. For these reasons, EBITDA multiples are most often used for mature businesses for which most of the value comes from the firm's existing assets. See Exhibit 8.2 for an illustration of how to apply this method.
Exhibit 8.2 Valuing a Target Firm Using the Enterprise Value to EBITDA Method
Repsol and Eni are geographically diversified integrated oil and gas companies. As of December 31, 2006, the market value of Repsol's common equity was $40.36 billion, and Eni's was $54.30 billion. Neither firm had preferred stock outstanding. Repsol's and Eni's outstanding debt consists primarily of interest-only notes with a balloon payment at maturity. The average maturity date for Repsol's debt is 12 years; for Eni's, it is 10 years. Market rates of interest for firms like Repsol and Eni at that time for debt maturing within 10 to 12 years were 7.5% and 7%, respectively. Repsol's and Eni's current income, balance sheet, and cash-flow statements as of December 31, 2006, are shown in the following table.
| Financial Statements | ||
| Repsol YPF | Eni SpA ($ billion) | |
| Income Statement (12/31/06) | ||
| Revenue | 72.70 | 114.70 |
| Cost of Sales | 48.60 | 75.90 |
| Other Expenses | 16.10 | 11.20 |
| Earnings before Interest and Taxes | 8.00 | 27.60 |
| Interest Expense | 0.70 | 0.30 |
| Earnings before Taxes | 7.30 | 27.30 |
| Taxes | 3.10 | 14.10 |
| Net Income | 4.20 | 13.20 |
| Balance Sheet (12/31/06) | ||
| Cash | 3.80 | 6.20 |
| Other Current Assets | 14.60 | 29.80 |
| Long-Term Assets | 42.70 | 77.20 |
| Total Assets | 61.10 | 113.20 |
| Current Liabilities | 13.30 | 28.30 |
| Long-Term Debt | 14.60 | 8.80 |
| Other Long-Term Liabilities | 8.80 | 26.40 |
| Total Liabilities | 36.70 | 63.50 |
| Shareholders' Equity | 24.40 | 49.70 |
| Equity + Total Liabilities | 61.10 | 113.20 |
| Cash Flow (12/31/06) | ||
| Net Income | 4.20 | 13.20 |
| Depreciation | 4.10 | 8.10 |
| Change in Working Capital | –0.40 | 1.10 |
| Investments | –6.90 | –9.30 |
| Financing | –1.20 | –9.40 |
| Change in Cash Balances | –0.20 | 3.70 |
Source: EDGAR Online
Which firm has the higher enterprise value to EBITDA ratio? (Hint: Use Eq. (8.2).)Answer: Repsol.
Enterprise to EBITDA Ratio
a The present value of debt is calculated using the PV of an annuity formula for 12 years and a 7.5% interest rate plus the PV of the principal repayment of $14.6 billion at the end of 12 years. Alternatively, rather than using the actual formulas, a present value interest factor annuity table and a present value interest factor table could have been used to calculate the PV of debt. Note that only annual interest expense of $0.7 million is used in the calculation of the PV of the annuity payment because the debt is treated as a balloon note.
b The present value of debt is calculated using the PV of an annuity formula for 10 years and a 7% interest rate plus the PV of the principal repayment of $8.8 billion at the end of 10 years.
c Note that a firm's financial statements frequently include depreciation expense in the cost of sales. Therefore, EBITDA may be calculated by adding EBIT from the income statement and depreciation expense shown on the cash-flow statement.
Adjusting Relative-Valuation Methods for Firm Growth Rates
Assume that Firm A and Firm B are direct competitors and have price-to-earnings ratios of 20 and 15, respectively. Which is the cheaper firm? It is not possible to answer this question without knowing how fast the earnings of the two firms are growing. The higher P/E ratio for Firm A may be justified if its earnings are expected to grow significantly faster than Firm B's future earnings.
For this reason, relative-valuation methods may be adjusted for differences in growth rates among firms. The most common adjustment is the PEG ratio, commonly calculated by dividing the firm's price-to-earnings ratio by the expected growth rate in earnings. This relative-valuation method is simple to compute and provides a convenient mechanism for comparing firms with different growth rates. The comparison of a firm's P/E ratio to its projected earnings is helpful in identifying stocks of firms that are under- or overvalued. Conceptually, firms with P/E ratios less than their projected growth rates may be considered undervalued, while those with P/E ratios greater than their projected growth rates may be viewed as overvalued. It is critical for the analyst to remember that growth rates by themselves do not increase multiples, such as a firm's price-to-earnings ratio, unless coupled with improving financial returns. Investors are willing to pay more for each dollar of future earnings only if they expect to earn a higher future rate of return. They may be willing to pay considerably more for a stock whose PEG ratio is greater than 1 if they believe the increase in earnings will result in future financial returns that significantly exceed the firm's cost of equity.
The PEG ratio can be helpful in evaluating the potential market values of a number of different firms in the same industry in selecting which may be the most attractive acquisition target. While the PEG ratio uses P/E ratios, other value indicators may be used. This method may be generalized as follows
(8.3)
where
A = PEG ratio—that is, market price–to–value indicator ratio (MV T /VI T ) relative to the growth rate of the value indicator (VITGR), which could include the growth in net income, cash flow, EBITDA, revenue, and the like.
VITGR = projected growth rate of the value indicator. Because this method uses an equity multiple (e.g., price per share/net income per share), consistency suggests that the growth rate in the value indicator should be expressed on a per-share basis. Therefore, if the value indicator is net income per share, the growth in the value indicator should be the growth rate for net income per share and not net income.
Equation (8.3) gives an estimate of the implied market value per share for a target firm based on its PEG ratio. As such, PEG ratios are useful for comparing firms whose expected future growth rates are positive and different to determine which is likely to have the higher firm value. For firms whose projected growth rates are 0 or negative, this method implies zero firm value for firms that are not growing and a negative value for those whose projected growth rates are negative. The practical implication for such firms is that those that are not growing are not likely to increase in market value, while those exhibiting negative growth are apt to experience declining firm values. Exhibit 8.3 illustrates how to apply the PEG ratio.
Exhibit 8.3 Applying the PEG Ratio
An analyst is asked to determine whether Basic Energy Service (BES) 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% and 9%, respectively. BES's and CPS's current earnings per share are $2.05 and $3.15, respectively. The current share prices as of June 25, 2008, for BES are $31.48 and for CPX are $26.00. The industry average price-to-earnings ratio and growth rate are 12.4 and 11%, respectively. Based on this information, which firm is a more attractive takeover target as of the point in time the firms are being compared? (Hint: Use Eq. (8.3).) The PEG ratio focuses on P/E ratios and earnings growth rates. What other factors if known might change your answer to the previous question?
Industry average PEG ratio: 12.4/0.11 = 112.73a
BES: Implied share price = 112.73 × 0.15 × $2.05 = $34.66
CPX: Implied share price = 112.73 × 0.09 × $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 this moment in time. However, BES could be a more attractive acquisition target than CPX if it can generate increasing future financial returns and if its projected earnings stream is viewed as less risky. Therefore, BES could exhibit greater potential and less uncertain future profitability than CPX.
Data Source: Yahoo! Finance.
Value-Driver-Based Valuation
In the absence of earnings, other factors that drive the creation of value for a firm may be used for valuation purposes. Such factors commonly are used to value start-up companies and initial public offerings, which often have little or no earnings performance records. Measures of profitability and cash flow are simply manifestations of value indicators. These indicators are dependent on factors both external and internal to the firm. Value drivers exist for each major function within the firm, including sales, marketing, and distribution; customer service; operations and manufacturing; and purchasing.
There are both micro value drivers and macro value drivers. Micro value drivers are those that directly influence specific functions within the firm. Micro value drivers for sales, marketing, and distribution could include product quality measures, such as part defects per 100,000 units sold, on-time delivery, the number of multiyear subscribers, and the ratio of product price to some measure of perceived quality. Customer service drivers could include average waiting time on the telephone, the number of billing errors as a percent of total invoices, and the time required to correct such errors. Operational value drivers include the average collection period, inventory turnover, and the number of units produced per manufacturing employee hour. Purchasing value drivers include average payment period, on-time vendor delivery, and the quality of purchased materials and services. Macro value drivers are more encompassing than micro value drivers in that they affect all aspects of the firm. Examples of macro value drivers include market share, overall customer satisfaction measured by survey results, total asset turns (i.e., sales to total assets), revenue per employee, and “same store sales” in retailing.
Using value drivers to value businesses is straightforward. First, the analyst needs to determine the key determinants of value (i.e., the value drivers for the target firm). Second, the market value for comparable companies is divided by the value driver selected for the target to calculate the dollars of market value per unit of value driver. Third, this figure is multiplied by the same indicator or value driver for the target company. For example, assume that the primary macro value driver or determinant of a firm's market value in a particular industry is market share. How investors value market share can be estimated by dividing the market leader's market value by its market share. If the market leader has a market value and market share of $300 million and 30%, respectively, the market is valuing each percentage point of market share at $10 million (i.e., $300 million ÷ 30). If the target company in the same industry has a 20% market share, an estimate of the market value of the target company is $200 million (20 points of market share times $10 million).
Similarly, the market value of comparable companies could be divided by other known value drivers. Examples include the number of visitors or page views per month for an Internet content provider, the number of subscribers to a magazine, cost per hotel room for a hotel chain, and the number of households with TVs in a specific geographic area for a cable TV company. Using this method, AT&T's acquisitions of the cable companies TCI and Media One in the late 1990s would appear to have been a “bargain.” AT&T spent an average of $5,000 per household (the price paid for each company divided by the number of customer households acquired) in purchasing these companies' customers. In contrast, Deutsche Telekom and Mannesmann spent $6,000 and $7,000 per customer, respectively, in buying mobile phone companies One 2 One and Orange PLC.7
The major advantage of this approach is its simplicity. Its major disadvantage is the implied assumption that a single value driver or factor is representative of the total value of the business. The bankruptcy of many dotcom firms between 2000 and 2002 illustrates how this valuation technique can be misused. Many of these firms had never shown any earnings, yet they exhibited huge market valuations. Investors often justified these valuations by using page views and subscribers of supposedly comparable firms to value any firm associated with the Internet. These proved to be poor indicators of the firm's ability to generate future earnings or cash flow.
Applying asset-oriented methods
What follows is a discussion of valuation based on applying tangible book value, liquidation value, and breakup value.
Tangible Book Value or Equity per Share Method
Book value is a much-maligned value indicator because book asset values rarely reflect actual market values (see Exhibit 8.4). They may over- or understate market value. For example, the value of land frequently is understated on the balance sheet, whereas inventory often is overstated if it is old or obsolete. The applicability of this approach varies by industry. Although book values generally do not mirror actual market values for manufacturing companies, they may be more accurate for distribution companies, whose assets are largely composed of inventory exhibiting high inventory turnover rates. Examples of such companies include pharmaceutical distributor Bergen Brunswick and personal computer distributor Ingram Micro. Book value is also widely used for valuing financial services companies, where tangible book value is primarily cash or liquid assets. Tangible book value is book value less goodwill.
Exhibit 8.4 Valuing Companies Using Book Value
Ingram Micro Inc. and its subsidiaries distribute information technology products worldwide. The firm's market price per share on August 21, 2008, was $19.30. Ingram's projected five-year average annual net income growth rate is 9.5%, and its beta is 0.89. The firm's shareholders' equity is $3.4 billion and goodwill is $0.7 billion. Ingram has 172 million (0.172 billion) shares outstanding. The following firms represent Ingram's primary competitors.
Ingram's tangible book value per share (VI T ) = ($3.4 – $0.7)/0.172 = $15.70
Based on risk as measured by the firm's beta and the five-year projected earnings growth rate, Synnex is believed to exhibit significantly different risk and growth characteristics from Ingram and is excluded from the calculation of the industry average market value to tangible book value ratio. Therefore, the appropriate industry average ratio (MVIND/VIIND) = 0.95—that is, (0.91 + 1.01 + 0.93)/3.
Ingram's implied value per share = MV T = (MVIND/VIIND) × VI T = 0.95 × $15.70 = $14.92
Data Source: Yahoo! Finance.
Liquidation or Breakup Value
The terms liquidation and breakup value often are used interchangeably. However, there are subtle distinctions. Liquidation or breakup value is the projected price of the firm's assets sold separately less its liabilities and expenses incurred in liquidating or breaking up the firm. Liquidation may be involuntary, as a result of bankruptcy, or voluntary, if a firm is viewed by its owners as worth more in liquidation than as a going concern. The going concern value of a company may be defined as the firm's value in excess of the sum of the value of its parts. Breakup and liquidation strategies are explored further in Chapters 15 and 16.
During the late 1970s and throughout most of the 1980s, highly diversified companies routinely were valued by investors in terms of their value if broken up and sold as discrete operations, as well as their going concern value as a consolidated operation. Companies lacking real synergy among their operating units or sitting on highly appreciated assets often were viewed as more valuable when broken up or liquidated. In early 2007, the Blackstone Group, a major private equity investor who acquired Equity Office Properties Trust (EOP) for $36 billion, moved aggressively to break up the business after having arranged the sale prior to closing of many of the properties held by the real estate investment trust.
Analysts may estimate the liquidation value of a target company to determine the minimum value of the company in the worst-case scenario of business failure and eventual liquidation. It is particularly appropriate for financially distressed firms. Analysts often make a simplifying assumption that the assets can be sold in an orderly fashion, which is defined as a reasonable amount of time to solicit bids from qualified buyers. Orderly fashion often is defined as 9 to 12 months. Under these circumstances, high-quality receivables typically can be sold for 80% to 90% of their book value. Inventories might realize 80 to 90% of their book value, depending on the condition and the degree of obsolescence. The value of inventory may also vary, depending on whether it consists of finished, intermediate, or raw materials. More rapid liquidation might reduce the value of inventories to 60 to 65% of their book value. The liquidation value of equipment varies widely depending on age and condition.
Inventories need to be reviewed in terms of obsolescence, receivables in terms of the ease with which they may be collected, equipment in terms of age and effectiveness, and real estate in terms of current market value. Equipment such as lathes and computers with a zero book value may have a significant economic value (i.e., useful life). Land can be a hidden source of value because it frequently is undervalued on GAAP balance sheets. Prepaid assets, such as insurance premiums, sometimes can be liquidated with a portion of the premium recovered. The liquidation value is reduced dramatically if the assets have to be liquidated in “fire sale” conditions, under which assets are sold to the first rather than the highest bidder (see Exhibit 8.5).
Exhibit 8.6 illustrates a hypothetical estimation of the breakup value of a firm consisting of multiple operating units. The implicit assumption is that the interdependencies among the four operating units are limited such that they can be sold separately without a significant degradation of the value of any individual unit.
Exhibit 8.5 Calculating Liquidation Value
Titanic Corporation has declared bankruptcy, and the firm's creditors have asked the trustee to estimate its liquidation value assuming orderly sale conditions. Note that this example does not take into account legal fees, taxes, management fees, and contractually required employee severance expenses. In certain cases, these expenses can comprise a substantial percentage of the proceeds from liquidation.
| Balance Sheet Item | Book Value ($ million) | Orderly Sale Value ($ million) |
| Cash | 100 | 100 |
| Receivables | 500 | 450 |
| Inventory | 800 | 720 |
| Equipment (after depreciation) | 200 | 60 |
| Land | 200 | 300 |
| Total Assets | 1,800 | 1,630 |
| Total Liabilities | 1,600 | 1,600 |
| Shareholders' Equity | 200 | 30 |
Exhibit 8.6 Calculating Breakup Value
Sea Bass Inc. consists of four operating units. The value of operating synergies among the units is believed to be minimal. All but $10 million in debt can be allocated to each of the four units. Such debt is associated with financing the needs of the corporate overhead structure. Legal, consulting, and investment banking fees, as well as severance expenses associated with terminating corporate overhead personnel, amount to $10 million. What is the breakup value of Sea Bass Inc.?
| Operating Unit | Estimated After-Tax Equity Value ($ million) |
| Unit 1 | 100 |
| Unit 2 | 125 |
| Unit 3 | 50 |
| Unit 4 | 75 |
| Total Equity Value | 350 |
| Less any unallocated liabilities held at the corporate level, corporate overhead expense, and costs associated with the breakup | 20 |
| Total Breakup Value | 330 |
The replacement cost method
The replacement cost approach estimates what it would cost to replace the target firm's assets at current market prices using professional appraisers less the present value of the firm's liabilities. The difference provides an estimate of the market value of equity. This approach does not take into account the going concern value of the company, which reflects how effectively the assets are being used in combination (i.e., synergies) to generate profits and cash flow. Valuing the assets separately in terms of what it would cost to replace them may seriously understate the firm's true going concern value. This approach may also be inappropriate if the firm has a significant amount of intangible assets on its books due to the difficulty in valuing such assets.
Valuing the firm using the weighted-average method
Predicting future cash flows and determining the appropriate discount rate are often very difficult. Consequently, relative-valuation multiples often are used in lieu of DCF valuation. However, no multiple is universally accepted as the best measure of a firm's value. Consequently, the weighted-average method of valuation represents a compromise position.8 This approach involves calculating the expected value (EXPV) or weighted average of a range of potential outcomes.
Note that the weights, which must sum to one, reflect the analyst's relative confidence in the various methodologies employed to value a business. Assuming that an analyst is equally confident in the accuracy of both methods, the expected value of a target firm valued at $12 million using discounted cash flow and $15 million using the comparable companies method can be written as follows:
Neither valuation method in this example includes a purchase price premium. Consequently, a premium will have to be added to the expected-value estimate to obtain a reasonable purchase estimate for the target firm.
Adjusting Valuation Estimates for Purchase Price Premiums
As explained in Chapter 1, the purchase premium reflects both the perceived value of obtaining a controlling interest in the target and the value of expected synergies (e.g., cost savings) resulting from combining the two firms . When using the weighted-average or expected-value valuation method, it is important to remember that unless adjusted to reflect a premium, the individual valuation methods discussed in Chapter 7 and in this chapter will not reflect the amount over market value that must be paid to gain a controlling interest in the target firm.
The exception is the recent transactions method, which already reflects a purchase price premium. The premium generally will be determined as a result of the negotiation process and should reflect premiums paid on recent acquisitions of similar firms and the percentage of synergy provided by the target firm. If the investor is interested in purchasing less than 100% of the voting shares of the target, it is necessary to adjust the purchase price for control premiums or minority discounts. How these adjustments are made is explained in detail in Chapter 10.9
Exhibit 8.7 illustrates a practical way of calculating the expected value of the target firm, including a purchase premium, using estimates provided by multiple valuation methods. In the example, the purchase price premium associated with the estimate provided by the recent comparable transactions method is applied to estimates provided by the other valuation methodologies.
Exhibit 8.7 Weighted-Average Valuation of Alternative Methodologies
An analyst has estimated the value of a company using multiple valuation methodologies. The discounted-cash-flow value is $220 million, the comparable transactions value is $234 million, the P/E-based value is $224 million, and the firm's breakup value is $200 million. The analyst has greater confidence in certain methodologies than others. The purchase price paid for the recent comparable transaction represented a 20% premium over the value of the firm at the time of the takeover announcement. Estimate the weighted-average value of the firm using all valuation methodologies and the weights or relative importance the analyst assigns to each methodology.
a Note that the comparable recent transactions estimate already contains a 20% purchase price premium.
Analyzing mergers and acquisitions in terms of real options
An option is the exclusive right, but not the obligation, to buy, sell, or use property for a specific period of time in exchange for a predetermined amount of money. Options traded on financial exchanges, such as puts and calls, are called financial options. Options that involve real assets, such as licenses, copyrights, trademarks, and patents, are called real options. Other examples of real options include the right to buy land, commercial property, and equipment. Such assets can be valued as call options if their current value exceeds the difference between the asset's current value and some predetermined level. For example, if a business has an option to lease office space at a predetermined price, the value of that option increases as lease rates for this type of office space increase. The asset can be valued as a put option if its value increases as the value of the underlying asset falls below a predetermined level. For example, if a business has an option to sell a commercial office building at a predetermined price, the value of that option increases as the value of the office building declines. In either instance, the option holder can choose to exercise (or not exercise) the option now or at some time in the future.
The term real options refers to management's ability to adopt and later revise corporate investment decisions. It should not be confused with a firm's strategic options, such as adopting a cost leadership, differentiation, or a focused business strategy (see Chapter 4). Since management's ability to adopt and subsequently change investment decisions can greatly alter the value of a project, it should be considered in capital budgeting methodology. If we view a merger or acquisition as a single project, real options should be considered as an integral part of M&A valuation.
Traditional DCF techniques fail to account for management's ability to react to new information and make decisions that affect the outcome of a project. However, real options can be costly to obtain (e.g., the right to extend a lease or purchase property), complex to value, and dependent on highly problematic assumptions. They should not be considered unless they are clearly identifiable, management has the time and resources to exploit them, and they would add significantly to the value of the underlying investment decision.10
Identifying Real Options Embedded in M&A Decisions
Investment decisions, including M&As, often contain certain “embedded options,” such as the ability to accelerate growth by adding to the initial investment (i.e., expand), delay the timing of the initial investment (i.e., delay), or walk away from the project (i.e., abandon). The case study at the beginning of this chapter illustrates the real options available to Microsoft in its attempt to take over Yahoo!. If Yahoo! were to accept Microsoft's early 2008 bid, Microsoft could choose to accelerate investment contingent on the successful integration of Yahoo! and MSN (i.e., option to expand) or spin off or divest the combined MSN/Yahoo! business if the integration effort were unsuccessful (option to abandon). Absent a negotiated agreement with Yahoo!, Microsoft could walk away, keeping open the possibility of returning to acquire or partner with Yahoo! at a later date if the Yahoo! board became more receptive (option to delay). Ultimately, Microsoft entered into a search partnership with Yahoo! in 2009.
In late 2008, Swiss mining company Xstrata PLC executed what could be characterized as an option to delay when it dropped its $10 billion bid for platinum producer Lonmin PLC because of its inability to get financing due to turmoil in the credit markets. However, Xstrata signaled that it would resume efforts to acquire Lonmin at a later date by buying 24.9% of the firm's depressed shares in the open market. Already owning 10.7% of the target's shares, the additional purchase gave Xstrata a 35.6% stake in Lonmin at a low average cost, effectively blocking potential competing bids. Drug company Eli Lilly's purchase of ImClone Systems for $6.5 billion in late 2008 at a sizeable 51% premium may have reflected an embedded option to expand. A significant portion of ImClone's future value seems to depend on the commercial success of future drugs derived from the firm's colon cancer–fighting drug Erbitux.
Frequently, the existence of the real option increases the value of the expected NPV of an investment. For example, the NPV of an acquisition of a manufacturer may have a lower value than if the NPV is adjusted for a decision made at a later date to expand capacity. If the additional capacity is fully utilized, the resulting higher level of future cash flows may increase the acquisition's NPV. In this instance, the value of the real option to expand is the difference between the NPV with and without expansion. An option to abandon an investment (i.e., divest or liquidate) often increases the NPV because of its effect on reducing risk. By exiting the business, the acquirer may be able to recover a portion of its original investment and truncate projected negative cash flows associated with the acquisition. Similarly, an acquirer may be able to increase the expected NPV by delaying the decision to acquire 100% of the target firm until the acquirer can be more certain about projected cash flows.
Preclosing Options and Associated Risks
Expand, delay, and abandon options exist in the period prior to closing an acquisition. An example of an option to delay closing occurs when a potential acquirer chooses to purchase a “toehold” position in the target firm to obtain leverage by acquiring voting shares in the target. The suitor is required to prenotify the target firm and publicly file its intentions with the SEC if its share of the target firm's outstanding stock reaches 5%. At this point the acquirer may choose to delay adding to its position or choose to move aggressively through a tender offer to achieve a controlling interest in the target firm. The latter option is an example of an option to expand its toehold position. An opportunity cost is associated with each choice. If the suitor fails to expand its position, additional bidders who are made aware of its intentions may bid up the target firm's share price to a level considered prohibitive by the initial potential acquirer. If the acquirer moves aggressively, it may lose the potential for reaching agreement with the target firm's board and management on friendly terms. The costs associated with a hostile takeover attempt include a potentially higher purchase price and the possible loss of key employees, customers, and suppliers during a more contentious integration of the target into the acquiring firm.
Other examples of delay options include an acquiring firm choosing to delay a merger until certain issues confronting the target are resolved, such as outstanding litigation or receiving regulatory approval (e.g., FDA approval for a new drug). The suitor may simply choose not to bid at that time and run the risk of losing the target firm to another acquirer or to negotiate an exclusive call option to buy the target at a predetermined price within a specified time period.
Normally, a breakup or termination fee is paid by the seller to the buyer if the seller decides to sell to another bidder following the signing of agreement of purchase and sale with the initial bidder. In a reverse termination fee arrangement, the bidder pays the seller a fee to withdraw from the transaction, often due to financial failure (i.e., the inability to obtain financing). The reverse fee could be viewed as a real option held by the buyer to abandon the deal. In mid-2008, Excel Technologies' shares traded at a 7.5% discount to a tender offer that was scheduled to close in 30 days. The size of the discount reflected investor concern that the buyer, GSI Group, would exercise its $9 million reverse termination fee to withdraw from the contract, since its stock had fallen by 35% since the deal's announcement, reflecting investor displeasure with the proposed takeover.
Postclosing Options and Associated Risks
Following closing, the acquirer also has the opportunity to expand, delay, or abandon new investment in the target firm. Acquiring firms generally have some degree of control over the timing of their investment decisions. For example, the acquiring firm's management may choose to make the level of investment in the target firm following closing contingent on the performance of actual cash flows compared to projected cash flows. If actual performance exceeds expectations, the acquirer may choose to accelerate its level of investment. In contrast, if performance is disappointing, the acquirer may opt to delay investment or even abandon the target firm either through divestiture or liquidation.
Valuing Real Options for Mergers and Acquisitions
Three ways to value real options are discussed in this book. The first is to use discounted cash flow, relative valuation, or asset-oriented methods and ignore alternative real options by assuming that their value is essentially zero. This suggests implicitly that management will not change the decision to invest once it has been made. The second is to value the real options in the context of a decision tree analysis. A decision tree is an expanded timeline that branches into alternative paths whenever an event can have multiple outcomes.11 The points at which the tree branches are called nodes. The decision tree is most useful whenever the investment decision is subject to a relatively small number of probable outcomes and the investment decision can be made in clearly defined stages. The third method involves the valuation of the real option as a put or call, assuming that the underlying asset has the characteristics of financial options. Valuing real options in this manner is often referred to as contingent claim valuation. A contingent claim is a claim that pays off only if certain events occur.
Several methods are employed for valuing financial options. The standard method for valuing a financial option is the Black-Scholes model, which is typically applied to “European options.” Such options can be exercised only at the expiration date of the option (i.e., a single, predefined date). This is an example of a “closed-form” model, in which the underlying assumptions do not vary over time. A more flexible, albeit often more complex, valuation method is a lattice-based option valuation technique, such as the binomial valuation model.12 While the binomial options model offers greater flexibility in terms of allowing assumptions to vary over time, the Black-Scholes offers greater simplicity. For this reason, the real options expressed as call or put options are valued in this book using the Black-Scholes method.13
Valuing Real Options Using a Decision Tree Framework
Table 8.3 illustrates how the presence of real options may affect the NPV associated with an acquisition in which management has identified two cash-flow scenarios (i.e., those associated with a successful acquisition and those with an unsuccessful one). Each pair of cash-flow scenarios is associated with what are believed to be the range of reasonable options associated with acquiring the target firm. These include the option to immediately proceed with, delay, or abandon the acquisition. Each outcome is shown as a “branch” on a tree. Each branch shows the cash flows and probabilities associated with each cash-flow scenario displayed as a timeline. The probability of realizing the “successful” cash-flow projections is assumed to be 60%; the “unsuccessful” one, 40%. The expected enterprise cash flow of the target firm is the sum of the projected cash flows of both the “successful” and “unsuccessful” scenarios multiplied by the estimated probability associated with each scenario. The target firm is assumed to have been acquired for $300 million, and the NPV is estimated using a 15% discount rate. The terminal value is calculated using the constant-growth method with an assumed terminal-period growth rate of 5%. With an NPV of –$7 million, the immediate investment option suggests that the acquisition should not be undertaken. However, the analyst should evaluate alternative options to determine if they represent attractive investment strategies.
Table 8.3. The Impact of Real Options on Valuing Mergers and Acquisitions
Note: The NPV for the delay option is discounted at the end of year 1, while the other options are discounted from year 0 (i.e., the present).
By recognizing that the target firm could be sold or liquidated, the expected NPV based on projected enterprise cash flows is $92 million, suggesting that the acquisition should be undertaken. This assumes that the target firm is sold or liquidated at the end of the third year following its acquisition for $152 million. Note that the cash flow in year 3 is $150 million, reflecting the difference between $152 million and the –$2 million in operating cash flow during the third year. The expected NPV with the option to delay is estimated at $34 million. Note that the investment is to be made after a one-year delay only if the potential acquirer feels confident that competitive market conditions will support the projected “successful” scenario cash flows. Consequently, the “unsuccessful” scenario's cash flows are zero.
Figure 8.2 summarizes the results provided in Table 8.3 in a decision tree framework. Of the three options analyzed, valuing the target including the value of the cash flows associated with the option to abandon would appear to be the most attractive investment strategy based on net present value (NPV). The values of the abandon and delay options are estimated as the difference between each of their NPVs and the NPV for the “immediate investment or acquisition” case.
Figure 8.2 Real-options decision tree.Note: See Table 8.3 for data.
Valuing Real Options Using the Black-Scholes Model
Options to assets whose cash flows have large variances and a long time before they expire are typically more valuable than those with smaller variances and less time remaining. The greater variance and time to expiration increase the chance that the factors affecting cash flows will change a project from one with a negative NPV to one with a positive NPV. If we know the values of five variables, we can use the Black-Scholes model to establish a theoretical price for an option. The limitations of the Black-Scholes model are the difficulty in estimating key assumptions (particularly risk), its assumptions that interest rates and risk are constant, that it can be exercised only on the expiration date, and that taxes and transaction costs are minimal. The basic Black-Scholes formula14 for valuing a call option is given as follows:
(8.4)
where
C = theoretical call option value
S = stock price or underlying asset price
R = risk-free interest rate corresponding to the life of the option
σ2 = variance (a measure of risk) of the stock's or underlying asset's return
t = time to expiration of the option
N(d 1) and N(d 2) = cumulative normal probability values of d 1 and d 2
The term Ee −Rt is the present value of the exercise price when continuous discounting is used. The terms N(d 1) and N(d 2), which involve the cumulative probability function, are the terms that take risk into account. N(d 1) and N(d 2) measure the probability that the value of the call option will pay off and the probability that the option will be exercised, respectively. These two values are Z-scores from the normal probability function, and they can be found in cumulative normal distribution function tables for the standard normal random variable in many statistics.
The variance (i.e., risk) to be used in the Black-Scholes model can be estimated in number of ways. First, risk could be estimated as the variance in the stock prices of similar firms or the assets whose cash flows enable the valuation of the option. For example, the average variance in the share prices of U.S. oil services companies could be used as the variance in the valuation of a real option associated with the potential purchase of an oil services firm.15 Second, the variance of cash flows from similar prior investments can be used. For example, drugs often require more than ten years and a cumulative expenditure of more than $1 billion before they become commercially viable. A pharmaceutical company may use the variance associated with the cash flows of previously developed comparable drugs in valuing an option to invest in a new drug. A third method is to use the standard deviation (i.e., the square root of the variance) calculated by using commonly available software to conduct Monte Carlo simulation analyses.16
Assuming that the necessary inputs (e.g., risk) can be estimated, a real option can be valued as a put or call option. The NPV of an investment can be adjusted for the value of the real option as follows:
(8.5)
Option to expand
To value a firm with an option to expand, the analyst must define the potential value of the option. For example, suppose a firm has an opportunity to enter a new market. The analyst must project cash flows that accrue to the firm if it enters the market. The cost of entering the market becomes the option's exercise price and the present value of the expected cash flows resulting from entering the market becomes the value of the firm or underlying asset. The present value is likely to be less than the initial entry costs, or the firm would already have entered the market. The variance of the firm's value can be estimated by using the variances of the market values of publicly traded firms that currently participate in that market. The option's life is the length of time during which the firm expects to achieve a competitive advantage by entering the market now. Exhibit 8.8 illustrates how to value an option to expand.
Exhibit 8.8 Valuing an Option to Expand Using the Black-Scholes Model
AJAX Inc. is negotiating to acquire Comet Inc. to broaden its product offering. Based on its projections of Comet's cash flows as a stand-alone business, AJAX cannot justify paying more than $150 million for Comet. However, Comet is insisting on a price of $160 million. Following additional due diligence, AJAX believes that by applying its technology, Comet's product growth rate could be accelerated significantly. By buying Comet, AJAX is buying an option to expand in a market in which it is not participating currently by retooling Comet's manufacturing operations. The cost of retooling to fully utilize AJAX's technology requires an initial investment of $100 million. The present value of the expected cash flows from making this investment today is $80 million. Consequently, based on this information, paying the higher purchase price cannot be justified by making the investment in retooling now.
However, if Comet (employing AJAX's new technology) could be first to market with the new product offering, it could achieve a dominant market share. While the new product would be expensive to produce in small quantities, the cost of production is expected to fall as larger volumes are sold, making Comet the low-cost manufacturer. Moreover, because of patent protection, AJAX believes that it is unlikely that competitors will be able to develop a superior technology for at least ten years. An analysis of similar investments in the past suggests that the variance of the projected cash flows is 20%. The option is expected to expire in ten years, reflecting the time remaining on AJAX's patent. The current ten-year Treasury bond rate (corresponding to the expected term of the option) is 6%. Is the value of the option to expand, expressed as a call option, sufficient to justify paying Comet's asking price of $160 million (see Eq. (8.4))?
Solution
| Value of the asset (PV of cash flows from retooling Comet's operations) | = $80 million |
| Exercise price (PV of the cost of retooling Comet's operations) | = $100 million |
| Variance of the cash flows | = 0.20 |
| Time to expiration | = 10 years |
| Risk-free interest rate | = .06 |
The net present value of the investment in retooling Comet's operations including the value of the call option is $28.61 million (i.e., $80 – $100 + $48.61). Including the value of the option, AJAX could pay Comet up to $178.61 million (i.e., $150 million + $28.61 million). Therefore, it does make sense for AJAX to exercise its option to retool Comet's operations, and AJAX can justify paying Comet its $160 million asking price.
Note: Z-values for d 1 and d 2 were obtained from a Cumulative Standardized Normal Distribution N(d) table in Levine, Berenson, and Stephan (1999), pp. E6–E7.
Option to delay
The underlying asset is the project to which the firm has exclusive rights. The current value is the present value of expected cash flows from undertaking the project now. The variance of cash flows from similar past projects or acquisitions can be used to estimate the variance for the project under consideration. A firm exercises an option to delay when it decides to postpone investing in a project. The option's exercise price is the cost of making the initial investment.
The option to delay expires whenever the exclusive rights to the project end. Since the option eventually expires, excess profits associated with having the option disappear as other competitors emerge to exploit the opportunity. This opportunity cost associated with delaying implementation of an investment is similar to an adjustment made to the Black-Scholes model for stocks that pay dividends. The payment of a dividend is equivalent to reducing the value of the stock, since such funds are not reinvested in the firm to support future growth. Consequently, for a project whose expected cash flows are spread evenly throughout the option period, each year the project is delayed, the firm will lose one year of profits that it could have earned. Therefore, the annual cost of delay is 1/n, where n is the time period for which the option is valid. If cash flows are not spread evenly, the cost of delay may be estimated as the projected cash flow for the next period as a percent of the current present value (see Exhibit 8.9). Equation (8.4) may be modified to reflect these considerations.
(8.6)
where
Exhibit 8.9 Valuing an Option to Delay Using the Black-Scholes Model
Aztec Corp. has an opportunity to acquire Pharmaceuticals Unlimited, which has a new cancer-fighting drug recently approved by the Food and Drug Administration. While current market studies indicate that the new drug's market acceptance will be slow due to competing drugs, it is believed that the drug will have meteoric growth potential in the long term as new applications are identified. The R&D and commercialization costs associated with exploiting new applications are expected to require an upfront investment of $60 million. However, Aztec can delay making this investment until it is more confident of the new drug's actual growth potential.
It is believed that Pharmaceuticals Unlimited's research and development efforts give it a five-year time period before competitors will have similar drugs on the market to exploit these new applications. However, if the higher growth for the new drug and its related applications do not materialize, Aztec estimates that the NPV for Pharmaceuticals Unlimited will be $(30). That is, if the new cancer-fighting drug does not realize its potential, it makes no sense for Aztec to acquire Pharmaceuticals Unlimited. Cash flows from previous drug introductions have exhibited a variance equal to 50% of the present value of the cash flows. Simulating alternative growth scenarios for this new drug provides an expected value of $40 million. The five-year Treasury bond rate (corresponding to the expected term of the option) is 6%. Despite the negative NPV associated with the acquisition, does the existence of the option to delay, valued as a call option, justify Aztec acquiring Pharmaceuticals Unlimited (see Eq. (8.6))?
Solution
| Value of the asset (PV of projected cash flows for the new drug) | = $40 million |
| Exercise price (investment required to fully develop the new drug) | = $60 million |
| Variance of the cash flows | = 0.5 |
| Time to expiration (t) | = 5 years |
| Risk-free interest rate | = 0.06 |
| Dividend yield or opportunity cost (cost of delay = 1/5) | = 0.2 |
The modest $4.86 million value of the call option is insufficient to offset the negative NPV of $30 million associated with the acquisition. Consequently, Aztec should not acquire Pharmaceuticals Unlimited.
Note: Z-values for d 1 and d 2 were obtained from a Cumulative Standardized Normal Distribution N(d) table in Levine, Berenson, and Stephan (1999), pp. E6–E7.
Option to abandon
For a project with a remaining life of n years, the value of continuing the project should be compared to its value in liquidation or sale (i.e., abandonment). The project should be continued if its value exceeds the liquidation value or sale value. Otherwise, the project should be abandoned. The option to abandon is equivalent to a put option (i.e., the right to sell an asset for a predetermined price at or before a stipulated time). The Black-Scholes formula for valuing a call option can be rewritten to value a put option (P) as follows (see Eq. (8.4)):
(8.7)
where
Exhibit 8.10 illustrates how the abandonment or put option can be applied.
Exhibit 8.10 Valuing an Option to Abandon Using the Black-Scholes Model
BETA Inc. has agreed to acquire a 30% ownership stake in Bernard Mining for $225 million to help finance the development of new mining operations. The mines are expected to have an economically useful life of 35 years. BETA estimates that the present value of its share of the cash flows would be $210 million, resulting in a negative NPV of $15 million (i.e., $210 million – $225 million). To induce BETA to make the investment, Bernard Mining has given BETA a put option enabling it to sell its share (i.e., abandon its investment) to Bernard at any point during the next five years for $175 million. The put option limits the downside risk to BETA.
In evaluating the terms of the deal, BETA needs to value the put option, whose present value will vary depending on when it is exercised. BETA estimates the average variance in the present values of future cash flows to be 20%, based on the variance of the share prices of publicly traded similar mining companies. Since the value of the mines will diminish over time as the reserves are depleted, the present value of the investment will diminish over time because there will be fewer years of cash flows remaining. The dividend yield or opportunity cost is estimated to be 1/number of years of profitable reserves remaining. The risk-free rate of return is 4%. Is the value of the put option sufficient to justify making the investment despite the negative net present value of the investment without the inclusion of the option value (see Eq. (8.7))?
Solution
| Present or expected value of BETA's 30% share of Bernard | = $210 million |
| Exercise price of put option | = $175 million |
| Time to expiration of put option | = 5 |
| Variance | = 20% |
| Dividend yield (1/35) | = 0.029 |
The value of the put option represents the additional value created by reducing risk associated with the investment. This additional value justifies the investment, as the sum of the NPV of $(15) million and the put option of $33.10 million gives a total NPV of $18.10 million.
Note: Z-scores for d 1 and d 2 were obtained from a cumulative Standardized Normal Distribution N(d) table in Levine, Berenson, and Stephan (1999), pp. E6–E7.
Determining when to use the different approaches to valuation
Table 8.4 summarizes the circumstances under which it would be most appropriate to use each valuation methodology. These methodologies include the discounted-cash-flow (DCF) approach discussed in detail in Chapter 7, as well as the relative, asset-oriented, replacement-cost, and contingent-claims methods (i.e., real options) discussed in this chapter. If the intention is to obtain a controlling interest in the firm, a control premium must be added to the estimated economic value of the firm to determine the purchase price. The exception is the comparable recent transactions method, which already contains a premium.
Table 8.4. When to Use Various Valuation Methodologies
Which valuation methods are actually used in practice
Practitioners tend to use price-to-earnings and cash-flow multiples in valuation more frequently than discounted-cash-flow models. The popularity of multiples reflects the combination of their relative simplicity and previously cited evidence that earnings and cash flow are highly positively correlated with stock returns over long periods such as five years or more. For shorter periods, earnings show a closer correlation with stock returns than cash flows. Cash-flow multiples are used for valuation when a firm's earnings are negative.
In a study of analysts and mutual fund managers in the United Kingdom, a researcher assessed the frequency of use of price-to-earnings ratios, dividend yields, price–to–free cash flow, sales-to-market capitalization, net asset value, and discounted cash flow. The author concluded that valuation multiples based on earnings and cash flow were the most common and DCF methods and dividend discount models were used the least.17 A study of 26 international investment banks showed that, while P/E-based models are most commonly used in valuation, investment bankers often resort to using various methods, including DCF models and price-to-sales multiples, depending on the situation (e.g., writing fairness opinion letters).18 A review of the Institutional Investor All-American Analyst Reports found market-to-book multiples were commonly used in valuing firms, while there was no evidence that DCF valuation was used.19
Some things to remember
Relative-valuation and asset-oriented techniques offer a variety of alternatives to the use of discounted-cash-flow estimates. The comparable companies approach entails the multiplication of certain value indicators for the target, such as earnings, by the appropriate valuation multiple for comparable companies. Similarly, the comparable transactions method involves the multiplication of the target's earnings by the same valuation multiple for recent, similar transactions. The comparable industry approach applies industry average multiples to earnings, to cash flow, to book value, or to sales. Asset-oriented methods, such as tangible book value, are very useful for valuing financial services companies and distribution companies. Liquidation or breakup value is the projected price of the firm's assets sold separately less its liabilities and associated expenses. Since no single valuation approach ensures accuracy, analysts often choose to use a weighted average of several valuation methods to increase their level of confidence in the final estimate.
The term real options refers to management's ability to revise corporate investment decisions after they have been made. Since real options can be costly, complex, and dependent on questionable assumptions, they should not be considered unless they are clearly identifiable and realizable, and significantly add to the value of the underlying investment.
Discussion Questions
8.1 Does the application of the comparable companies valuation method require the addition of an acquisition premium? Why or why not?
8.2 Which is generally considered more accurate: the comparable companies or recent transactions method? Explain your answer.
8.3 What key assumptions are implicit in using the comparable companies valuation method? The recent comparable transactions method?
8.4 Explain the primary differences between the income (discounted cash flow), market-based, and asset-oriented valuation methods.
8.5 Under what circumstances might it be more appropriate to use relative-valuation methods rather than the DCF approach? Be specific.
8.6 PEG ratios allow for the adjustment of relative-valuation methods for the expected growth of the firm. How might this be helpful in selecting potential acquisition targets? Be specific.
8.7 How is the liquidation value of the firm calculated? Why is the assumption of orderly liquidation important?
8.8 What are real options and how are they applied in valuing acquisitions?
8.9 Give examples of pre- and postclosing real options. Be specific.
8.10 Conventional DCF analysis does not incorporate the effects of real options into the valuation of an asset. How might an analyst incorporate the potential impact of real options into conventional DCF valuation methods?
Answers to these Chapter Discussion Questions are available in the Online Instructor's Manual for instructors using this book.
Practice Problems and Answers
8.11 BigCo's chief financial officer is trying to determine a fair value for PrivCo, a nonpublicly traded firm that BigCo is considering acquiring. Several of PrivCo's competitors, Ion International and Zenon, are publicly traded. Ion and Zenon have P/E ratios of 20 and 15, respectively. Moreover, Ion and Zenon's shares trade at a multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA) of 10 and 8, respectively. BigCo estimates that next year, PrivCo will achieve net income and EBITDA of $4 million and $8 million, respectively. To gain a controlling interest in the firm, BigCo expects to have to pay at least a 30% premium to the firm's market value. What should BigCo expect to pay for PrivCo?
8.12 LAFCO Industries believes that its two primary product lines, automotive and commercial aircraft valves, are becoming obsolete rapidly. Its free cash flow is diminishing quickly as it loses market share to new firms entering its industry. LAFCO has $200 million in debt outstanding. Senior management expects the automotive and commercial aircraft valve product lines to generate $25 million and $15 million, respectively, in earnings before interest, taxes, depreciation, and amortization next year. The operating liabilities associated with these two product lines are minimal. Senior management also believes that it will not be able to upgrade these product lines because of declining cash flow and excessive current leverage. A competitor to its automotive valve business last year sold for 10 times EBITDA. Moreover, a company similar to its commercial aircraft valve product line sold last month for 12 times EBITDA. Estimate LAFCO's breakup value before taxes.
8.13 Siebel Incorporated, a nonpublicly traded company, has 2009 after-tax earnings of $20 million, which are expected to grow at 5% annually into the foreseeable future. The firm is debt free, capital spending equals the firm's rate of depreciation, and the annual change in working capital is expected to be minimal. The firm's beta is estimated to be 2.0, the ten-year Treasury bond is 5%, and the historical risk premium of stocks over the risk-free rate is 5.5%. Publicly traded Rand Technology, a direct competitor of Siebel's, was sold recently at a purchase price of 11 times its 2009 after-tax earnings, which included a 20% premium over its current market price. Aware of the premium paid for the purchase of Rand, Siebel's equity owners would like to determine what it might be worth if they were to attempt to sell the firm in the near future. They choose to value the firm using the discounted-cash-flow and comparable recent transactions methods. They believe that either method provides an equally valid estimate of the firm's value.
a. What is the value of Siebel using the DCF method?
b. What is the value using the comparable recent transactions method?
c. What will be the value of the firm if we combine the results of both methods?
8.14 Titanic Corporation reached an agreement with its creditors to voluntarily liquidate its assets and use the proceeds to pay off as much of its liabilities as possible. The firm anticipates that it will be able to sell off its assets in an orderly fashion, realizing as much as 70% of the book value of its receivables, 40% of its inventory, and 25% of its net fixed assets (excluding land). However, the firm believes that the land on which it is located can be sold for 120% of book value. The firm has legal and professional expenses associated with the liquidation process of $2.9 million. The firm has only common stock outstanding. Using Table 8.5, estimate the amount of cash that will remain for the firm's common shareholders once all assets have been liquidated.
8.15 Best's Foods is seeking to acquire the Heinz Baking Company, whose shareholders' equity and goodwill are $41 million and $7 million, respectively. A comparable bakery was recently acquired for $400 million, 30% more than its tangible book value (TBV). What was the tangible book value of the recently acquired bakery? How much should Best's Foods expect to have to pay for the Heinz Baking Company? Show your work.
Answer: The TBV of the recently acquired bakery = $307.7 million, and the likely purchase price of Heinz = $44.2 million.
8.16 Delhi Automotive Inc. is the leading supplier of specialty fasteners for passenger cars in the U.S. market, with an estimated 25% share of this $5 billion market. Delhi's rapid growth in recent years has been fueled by high levels of reinvestment in the firm. While this has resulted in the firm having “state-of-the-art” plants, it also has resulted in the firm showing limited profitability and positive cash flow. Delhi is privately owned and has announced that it is going to undertake an initial public offering in the near future. Investors know that economies of scale are important in this high-fixed-cost industry and understand that market share is an important determinant of future profitability. Thornton Auto Inc., a publicly traded firm and the leader in this market, has an estimated market share of 38% and an $800 million market value. How should investors value the Delhi IPO? Show your work.
8.17 Photon Inc. is considering acquiring one of its competitors. Photon's management wants to buy a firm it believes is most undervalued. The firm's three major competitors, AJAX, BABO, and COMET, have current market values of $375 million, $310 million, and $265 million, respectively. AJAX's FCFE is expected to grow at 10% annually, while BABO's and COMET's FCFEs are projected to grow by 12 and 14% per year, respectively. AJAX, BABO, and COMET's current-year FCFEs are $24, $22, and $17 million, respectively. The industry average price-to-FCFE ratio and growth rate are 10 and 8%, respectively. Estimate the market value of each of the three potential acquisition targets based on the information provided. Which firm is the most undervalued? Which firm is most overvalued? Show your work. Answer: AJAX is most overvalued and COMET is most undervalued.
8.18 Acquirer Incorporated's management believes that the most reliable way to value a potential target firm is by averaging multiple valuation methods, since all methods have their shortcomings. Consequently, Acquirer's chief financial officer estimates that the value of Target Inc. could range, before an acquisition premium is added, from a high of $650 million using discounted-cash-flow analysis to a low of $500 million using the comparable companies relative-valuation method. A valuation based on a recent comparable transaction is $672 million. The CFO anticipates that Target Inc.'s management and shareholders would be willing to sell for a 20% acquisition premium, based on the premium paid for the recent comparable transaction. The CEO asks the CFO to provide a single estimate of the value of Target Inc. based on the three estimates. In calculating a weighted average of the three estimates, she gives a value of 0.5 to the recent transactions method, 0.3 to the DCF estimate, and 0.2 to the comparable companies estimate. What is the weighted-average estimate she gives to the CEO? Show your work.
8.19 An investor group has the opportunity to purchase a firm whose primary asset is ownership of the exclusive rights to develop a parcel of undeveloped land sometime during the next five years. Without considering the value of the option to develop the property, the investor group believes the net present value of the firm is $(10) million. However, to convert the property to commercial use (i.e., exercise the option), the investors have to invest $60 million immediately in infrastructure improvements. The primary uncertainty associated with the property is how rapidly the surrounding area will grow. Based on their experience with similar properties, the investors estimate that the variance of the projected cash flows is 5% of NPV, which is $55 million. Assume the risk-free rate of return is 4%. What is the value of the call option the investor group would obtain by buying the firm? Is it sufficient to justify the acquisition of the firm? Show your work.
Answer: The value of the option is $13.47 million. The investor group should buy the firm, since the value of the option more than offsets the $(10) million NPV of the firm if the call option were not exercised.
8.20 Acquirer Company's management believes that there is a 60% chance that Target Company's free cash flow will grow at 20% per year during the next five years from this year's level of $5 million. Sustainable growth beyond the fifth year is estimated at 4% per year. However, management also believes that there is a 40% chance that cash flow will grow at half that annual rate during the next five years, and then at a 4% rate thereafter. The discount rate is estimated to be 15% during the high-growth period and 12% during the sustainable-growth period. What is the expected value of Target Company?
Table 8.5. Titanic Corporation Balance Sheet
| Balance Sheet Item | Book Value of Assets | Liquidation Value |
| Cash | $10 | |
| Accounts receivable | $20 | |
| Inventory | $15 | |
| Net fixed assets excluding land | $8 | |
| Land | $6 | |
| Total assets | $59 | |
| Total liabilities | $35 | |
| Shareholders' equity | $24 |
Answers to these Practice Problems are available in the Online Instructor's Manual for instructors using this book.
Chapter business cases
Case Study 8.1
Google Buys YouTube: Valuing a Firm in the Absence of Cash Flows
YouTube ranks as one of the most heavily utilized sites on the Internet, with 1 billion views per day, 20 hours of new video uploaded every minute, and 300 million users worldwide. Despite the explosion in usage, Google continues to struggle to “monetize” the traffic on the site five years after having acquired the video sharing business. 2010 marked the first time the business turned marginally profitable.20Whether the transaction is viewed as successful depends on whether it is evaluated on a stand-alone basis or as part of a larger strategy designed to steer additional traffic to Google sites and promote the brand.
This case study illustrates how a value driver approach to valuation could have been used by Google to estimate the potential value of YouTube by collecting publicly available data for a comparable business. Note the importance of clearly identifying key assumptions underlying the valuation. The credibility of the valuation ultimately depends on the credibility of the assumptions.
Google acquired YouTube in late 2006 for $1.65 billion in stock. At that time, the business had been in existence only for 14 months, consisted of 65 employees, and had no significant revenues. However, what it lacked in size it made up in global recognition and a rapidly escalating number of site visitors. Under pressure to continue to fuel its own meteoric 77% annual revenue growth rate, Google moved aggressively to acquire YouTube in an attempt to assume center stage in the rapidly growing online video market. With no debt, $9 billion in cash, and a net profit margin of about 25%, Google was in remarkable financial health for a firm growing so rapidly. The acquisition was by far the most expensive by Google in its relatively short eight-year history. In 2005, Google spent $130.5 million in acquiring 15 small firms. Google seemed to be placing a big bet that YouTube would become a huge marketing hub as its increasing number of viewers attracted advertisers interested in moving from television to the Internet.
Started in February 2005 in the garage of one of the founders, YouTube displayed in 2006 more than 100 million videos daily and had an estimated 72 million visitors from around the world each month, of which 34 million were unique.21 As part of Google, YouTube retained its name and current headquarters in San Bruno, California. In addition to receiving funding from Google, YouTube was able to tap into Google's substantial technological and advertising expertise.
To determine if Google is likely to earn its cost of equity on its investment in YouTube, we have to establish a base-year free-cash-flow estimate for YouTube. This may be done by examining the performance of a similar but more mature website, such as about.com. Acquired by The New York Times in February 2005 for $410 million, about.com is a website offering consumer information and advice and is believed to be one of the biggest and most profitable websites on the Internet, with estimated 2006 revenues of almost $100 million. With a monthly average number of unique visitors worldwide of 42.6 million, about.com's revenue per unique visitor was estimated to be about $0.15, based on monthly revenues of $6.4 million.22
Assuming that these numbers could be duplicated by YouTube within the first full year of ownership by Google, YouTube could potentially achieve monthly revenue of $5.1 million (i.e., $0.15 per unique visitor × 34 million unique YouTube visitors) by the end of the year. Assuming net profit margins comparable to Google's 25%, YouTube could generate about $1.28 million in after-tax profits on those sales. If that monthly level of sales and profits could be sustained for the full year, YouTube could achieve annual sales in the second year of $61.2 million (i.e., $5.1 × 12) and profit of $15.4 million ($1.28 × 12). Assuming optimistically that capital spending and depreciation grow at the same rate and that the annual change in working capital is minimal, YouTube's free cash flow would equal after-tax profits.
Recall that a firm earns its cost of equity on an investment whenever the net present value of the investment is zero. Assuming a risk-free rate of return of 5.5%, a beta of 0.82 (per Yahoo! Finance), and an equity premium of 5.5%, Google's cost of equity would be 10%. For Google to earn its cost of equity on its investment in YouTube, YouTube would have to generate future cash flows whose present value would be at least $1.65 billion (i.e., equal to its purchase price). To achieve this result, YouTube's free cash flow to equity would have to grow at a compound annual average growth rate of 225% for the next 15 years, and then 5% per year thereafter. Note that the present value of the cash flows during the initial 15-year period would be $605 million and the present value of the terminal period cash flows would be $1,005 million. Using a higher revenue per unique visitor assumption would result in a slower required annual growth rate in cash flows to earn the 10% cost of equity. However, a higher discount rate might be appropriate to reflect YouTube's higher investment risk. Using a higher discount rate would require revenue growth to be even faster to achieve an NPV equal to zero.
Google could easily have paid cash, assuming that the YouTube owners would prefer cash to Google stock. Perhaps Google saw its stock as overvalued and decided to use it now to minimize the number of new shares that it would have had to issue to acquire YouTube, or perhaps YouTube shareholders simply viewed Google stock as more attractive than cash.
With YouTube having achieved marginal profitability in 2010, it would appear that the valuation assumptions implicit in Google's initial valuation of YouTube may, indeed, have been highly optimistic. While YouTube continues to be wildly successful in terms of the number of site visits, with unique monthly visits having increased almost sixfold from their 2006 level, it appears to be disappointing at this juncture in terms of profitability and cash flow. The traffic continues to grow as a result of integration with social networks such as Facebook and initiatives such as the ability to send clips to friends as well as to rate and comment on videos. Moreover, YouTube is showing some progress in improving profitability by continuing to expand its index of professionally produced premium content. Nevertheless, on a stand-alone basis, it is problematic that YouTube will earn Google's cost of equity. However, as part of a broader Google strategy involving multiple acquisitions to attract additional traffic to Google and to promote the brand, the purchase may indeed make sense.
Discussion Questions
1. What alternative valuation methods could Google have used to justify the purchase price it paid for YouTube? Discuss the advantages and disadvantages of each.
2. The purchase price paid for YouTube represented more than 1% of Google's then market value. If you were a Google shareholder at that time, how might you have evaluated the wisdom of the acquisition?
3. To what extent might the use of stock by Google have influenced the amount it was willing to pay for YouTube? How might the use of “overvalued” shares impact future appreciation of the stock?
4. What is the appropriate cost of equity for discounting future cash flows? Should it be Google's or YouTube's? Explain your answer.
5. What are the critical valuation assumptions implicit in the valuation method discussed in this case study? Be specific.
Answers to these questions are provided in the Online Instructor's Guide accompanying this manual.
Case Study 8.2
Merrill Lynch and BlackRock Agree to Swap Assets
During the 1990s, many financial services companies began offering mutual funds to their current customers who were pouring money into the then booming stock market. Hoping to become financial supermarkets offering an array of financial services to their customers, these firms offered mutual funds under their own brand name. The proliferation of mutual funds made it more difficult to be noticed by potential customers and required the firms to boost substantially advertising expenditures at a time when increased competition was reducing mutual fund management fees. In addition, potential customers were concerned that brokers would promote their own firm's mutual funds to boost profits.
This trend reversed in recent years, as banks, brokerage houses, and insurance companies were exiting the mutual fund management business. Merrill Lynch agreed on February 15, 2006, to swap its mutual funds business for an approximate 49% stake in money-manager BlackRock Inc. The mutual fund or retail accounts represented a new customer group for BlackRock, founded in 1987, which had previously managed primarily institutional accounts.
At $453 billion in 2005, BlackRock's assets under management had grown four times faster than Merrill's $544 billion mutual fund assets. During 2005, BlackRock's net income increased to $270 million, or 63% over the prior year, as compared to Merrill's 27% growth in net income in its mutual fund business to $397 million. BlackRock and Merrill stock traded at 30 and 19 times estimated 2006 earnings, respectively.
Merrill assets and net income represented 55% and 60% of the combined BlackRock and Merrill assets and net income, respectively. Under the terms of the transaction, BlackRock would issue 65 million new common shares to Merrill. Based on BlackRock's February 14, 2005, closing price, the deal is valued at $9.8 billion. The common stock gave Merrill 49% of the outstanding BlackRock voting stock. PNC Financial and employees and public shareholders owned 34% and 17%, respectively. Merrill's ability to influence board decisions is limited, since it has only 2 of 17 seats on the BlackRock board of directors. Certain “significant matters” require a 70% vote of all board members and 100% of the nine independent members, which include the two Merrill representatives. Merrill (along with PNC) must also vote its shares as recommended by the BlackRock board.
Discussion Questions
1. Merrill owns less than half of the combined firms, although it contributed more than one-half of the combined firms' assets and net income. Discuss how you might use DCF and relative-valuation methods to determine Merrill's proportionate ownership in the combined firms.
2. Why do you believe Merrill was willing to limit its influence in the combined firms?
3. What method of accounting would Merrill use to show its investment in BlackRock?
Answers to these questions are found in the Online Instructor's Manual for instructors using this manual.
1 For a more detailed discussion of these issues, see Stowe et al. (2007).
2 Rather than using a financial return to measure profitability, the actual dollar value of profits could be used to identify firms that are also comparable in size.
3 As noted in Chapter 7, smaller firms, other things being equal, are more prone to default than larger firms, which generally have a larger asset base and a larger and more diversified revenue stream than smaller firms. Consequently, the analyst should take care not to compare firms that are substantially different in size unless convinced that the firms are truly comparable in terms of profitability, growth, and risk.
4 Moonchul and Ritter, 1999; Liu, Nissim, and Thomas, 2002
5 In valuation, differences in earnings, cash flows, and dividends are often attributable to timing differences (i.e., differences between when a cash outlay is recorded and when it is actually incurred). For example, when a firm buys a piece of equipment, it generally pays for the equipment in the period in which it is received. However, for financial reporting purposes, the purchase price of the equipment is amortized over its estimated useful life. Proponents of using earnings as a measure of value rather than cash flow argue that earnings reflect value changes regardless of when they occur. For example, a firm's contractual obligation to provide future health care or pension benefits when an employee retires is reflected in current compensation and reduces earnings by an expense equal to the present value of that deferred compensation. In contrast, current cash flows are unaffected by this obligation. The bottom line is that, over the life of the firm, the present values of future earnings, cash flows, and dividends will be equal if based on internally consistent assumptions. See Lui et al. (2002).
6 Cheng, Liu, and Schaefer, 1996; Dechow, 1994; Sloan, 1996. For a sample of 25,843 firms in ten countries from 1987 to 2004, Liu, Nissim, and Thomas (2007) argue that forecasted earnings may be better predictors of firm value than projected cash flows. The authors found that industry multiples based on forecasted earnings are superior predictors of actual equity values of firms traded on public stock exchanges than industry multiples based forecasted cash flow. Forecasted earnings also were found to be superior as a measure of value than dividend-based valuations. Kaplan and Ruback (1995) and Kim and Ritter (1999) argue that the choice of which multiple or method (relative valuation or DCF) to use is ambiguous. Furthermore, for a sample of 51 highly leveraged transactions between 1983 and 1989, Kaplan and Ruback question whether one forecasting method is superior to another by noting that both the DCF and the relative multiple methods exhibit similar levels of valuation accuracy.
a Solving MVT = A × VITGR × VIT using an individual firm's PEG ratio provides the firm's current or 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 firm's 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.
8 Kaplan and Ruback (1995) and Liu et al. (2002) provide empirical support for using multiple methods of valuation to estimate the economic value of an asset.
9 Adjustments to estimated market values should be made with care. For example, the analyst should be careful not to mechanically add an acquisition premium to the target firm's estimated value based on the comparable companies method if there is evidence that the market values of “comparable firms” already reflect the effects of acquisition activity elsewhere in the industry. For example, rival firms' share prices will rise in response to the announced acquisition of a competitor, regardless of whether the proposed acquisition is ultimately successful or unsuccessful (Song and Walking, 2000). Akhigbe, Borde, and Whyte (2000) find that the increase in rivals' share prices may be even greater if the acquisition attempt is unsuccessful because investors believe that the bidder will attempt to acquire other firms in the same industry. There is evidence that the effects of merger activity in one country are also built into merger premiums in other countries in regions that are becoming more integrated, such as the European Union (Bley and Medura, 2003).
10 For an intuitive discussion of real options, see Boer (2002); for a more rigorous discussion of applying real options, see Damodaran (2002, pp. 772–815).
11 See Lasher (2005), pp. 428–433.
12 Such models are sometimes used to value so-called American options, which may be exercised at any time before the expiration date. The binomial option-pricing model is based on the notion that the value of the underlying asset in any time period can change in one of two directions (i.e., either up or down), thereby creating a lattice of alternative asset pricing points. Because the lattice model, unlike the Black-Scholes model, values the asset (e.g., stock price) underlying the option at various points in time, such important economic assumptions as risk and the risk-free rate of return can be assumed to vary over time. While the binomial model allows for changing key assumptions over time, it often requires a large number of inputs, in terms of expected future prices at each node or pricing point.
13 For a recent discussion of alternative real-option valuation methods, see Hitchner (2006).
14 Modified versions of the Black–Scholes model are discussed in Arzac (2006).
15 In another example, assume a potential acquirer of an oil company recognizes that, in buying the target, it would have a call option (real option to expand) to develop the firm's oil reserves at a later date. The acquirer could choose to value the target firm as a stand-alone entity and the option to develop the firm's reserves at some time in the future separately. Assuming the volume of reserves is known with certainty, the variance in world oil prices may be used as a proxy for the risk associated with an option to develop the reserves. If there is uncertainty with respect to the volume of reserves and the price of oil, the uncertainties can be combined by recognizing that the value of the reserves represents the price of oil times the quantity of reserves and estimating the variance of the dollar value of the reserves.
16 For each simulation, a range of outcomes is generated based on the predefined probability distributions provided by the analyst for the inputs (e.g., sales growth, inflation) driving the cash flows. The analyst selects one outcome from each simulation and calculates the present values of the cash flows based on the selected outcomes. The average of the range of present values calculated from running repeated simulations is the expected value of the project. By squaring the standard deviation associated with the range of present values, a variance can be calculated to be used in valuing the real option.
21 Unique visitors are those whose IP addresses are counted only once no matter how many times they visit a website during a given period.
22 Aboutmediakit, September 17, 2006, http://beanadvertiser.about.com/archive/news091606.html.