Applying Relative, Asset Oriented,
and Real Option Valuation Methods to
Mergers and Acquisitions
You earn a living by what you get,
but you build a life by what you give.
—Winston Churchill
Exhibit 1: Course Layout: Mergers,
Acquisitions, and Other
Restructuring Activities
Part I: M&A
Environment
Part II: M&A Process
Part III: M&A
Valuation and
Modeling
Part IV: Deal
Structuring and
Financing
Part V: Alternative
Business and
Restructuring
Strategies
Ch. 1: Motivations for
M&A
Ch. 4: Business and
Acquisition Plans
Ch. 7: Discounted
Cash Flow Valuation
Ch. 11: Payment and
Legal Considerations
Ch. 15: Business
Alliances
Ch. 2: Regulatory
Considerations
Ch. 5: Search through
Closing Activities
Ch. 8: Relative
Valuation
Methodologies
Ch. 12: Accounting &
Tax Considerations
Ch. 16: Divestitures,
Spin-Offs, Split-Offs,
and Equity Carve-Outs
Ch. 3: Takeover
Tactics, Defenses, and
Corporate Governance
Ch. 6: M&A
Postclosing Integration
Ch. 9: Financial
Modeling Techniques
Ch. 13: Financing the
Deal
Ch. 17: Bankruptcy
and Liquidation
Ch. 10: Private
Company Valuation
Ch. 14: Valuing
Highly Leveraged
Transactions
Ch. 18: Cross-Border
Transactions
Learning Objectives
• Primary learning objective: To provide students with knowledge of
alternatives to discounted cash flow valuation methods, including
– Market Approach
• Comparable companies
• Comparable transactions
• Same industry or comparable industry
– Asset oriented approach
• Tangible book value
• Liquidation value
• Break-up value
– Replacement Cost approach
– Weighted average method
• Secondary learning objective: Enable students to understand how
real options apply to M&As
Applying Market-Based (Relative
Valuation) Methods1
MVT = (MVC / VIC) x VIT
Where
MVT
MVC
VIC
VIT
(MVC/VIC)
1Comparable
= Market value of target company
= Market value of the comparable company C2
= Measure of value for comparable company C
= Measure of value for company T
= Market value multiple for the comparable
company
companies may include those with profitability, risk, and growth characteristics similar to the target firm; they are not
necessarily found in the same industry as the target firm. Risk may be measured by the beta and the D/E or D/TC ratios.
2To identify comparable firms, calculate correlation coefficients with respect to revenue, profit, or cash flows of firms in the same
or similar industries.
Relationship Between DCF and
Market Multiples
Perpetuity DCF Model and P (price per share)/E (earnings per share) ratios:
P = E / ke (perpetuity model), dividing both sides by E gives
P / E = $1 / ke, which is the amount investors are willing to pay for $1 of earnings in
perpetuity
ex. If E = $1, the earnings payout ratio is 100%, and ke is 10%, then
P / E = $1 / .10 = $10 per dollar of earnings
Constant Growth DCF Model and P/E ratios:
PV = E (1 + g) / (ke – g) (constant growth model), dividing both sides by E
P / E = $1(1 + g) / (ke – g), the amount investors are willing to pay for $1 of
earnings growing at a constant growth rate g.
ex. If E = $1, the earnings payout ratio is 100%, ke is 10%, and the earnings growth rate
is 5%, then
P / E = $1 x 1.00 x (1.05) / (.10 - .05) = $21 per dollar of earnings.
Key Point: When comparing firms with different P/E ratios, which is more attractive depends
on the expected earnings growth rate, payout ratio, and rate at which earnings can be
reinvested.
Market-Based Methods: Comparable Company Example
Exhibit 8-1. Valuing Repsol YPF Using Comparable Integrated Oil Companies
Target Valuation Based on Following Multiples (MVC/VIC):
Comparable Company
Exxon Mobil Corp (XOM)
Trailing P/E1
Forward
P/E2
Price/Sales
Price/Book
Col. 1
Col. 2
Col. 3
Col. 4
11.25
8.73
1.17
3.71
9.18
7.68
0.69
2.17
10.79
8.05
0.91
2.54
7.36
8.35
0.61
1.86
11.92
6.89
0.77
1.59
Total SA (TOT)
8.75
8.73
0.80
2.53
Eni SpA (E)
3.17
7.91
0.36
0.81
11.96
10.75
1.75
2.10
9.30
8.39
0.88
2.16
$4.38
$3.27
$92.66
$26.49
$40.73
$27.44
$81.54
$57.22
British Petroleum (BP)
Chevron Corp (CVX)
Royal Dutch Shell (RDS-B)
ConocoPhillips (COP)
PetroChina Co. (PTR)
Average Multiple (MVC/VIC) Times
Repsol YPF Projections (VIT)3
Equals Estimated Mkt. Value of Target3
1Trailing
52 week average. 2Projected 52 week average. 3Billions of Dollars.
Key Points: 1. Firm valuation differs significantly depending on valuation multiple used.
2. Valuation estimates require addition of a purchase price premium.
Average
Col. 1-4
$51.73
Market-Based Methods:
Recent Transactions’ Method1
•
Calculation similar to comparable companies’ method, except multiples used to
estimate target’s value based on purchase prices of recent transactions of
comparable companies.
MVT = (MVRT / VIRT) x VIT
Where
MVT
= Market value of target company T
MVRT
= Market value of the recently acquired comparable company RT
VIRT
= Measure of value for recently acquired comparable company RT
VIT
= Measure of value for target company T
(MVRT/VIRT) = Market value multiple for the recently acquired comparable company RT
•
•
•
Most accurate method whenever the transaction is truly comparable and very
recent.
Major limitation is that truly comparable recent transactions are rare.
Valuations based on this method already include a purchase price premium
1Also
called precedent method.
Market-Based Methods:
Same or Comparable Industry Method
•
Multiply target’s earnings or revenues by market value to earnings or revenue ratios
for the average firm in target’s industry or a comparable industry.
MVT = (MVAF / VIAF) x VIT
Where
MVT
MVAF
VIAF
VIT
(MVAF/VIAF)
•
•
•
= Market value of target firm
= Market value of average firm (AF) in target firm’s or comparable industry
= Measure of value for average firm in target firm’s or comparable Industry
= Measure of value for target company T
= Market value multiple for the average firm in target firm’s or comparable
industry
Primary advantage is the ease of use and availability of data.
Disadvantages include presumption industry multiples are actually comparable and
analysts’ projections are unbiased.
Requires addition of purchase price premium
PEG Ratio
•
•
•
Firm A and Firm B have P/Es of 20 and 15, respectively. Which is more attractive?
PEG Ratio used to adjust relative valuation methods for differences in growth rates
among comparable firms.
Helpful in determining which of a number of different firms in same industry exhibiting
different growth rates may be the most attractive.
(MVT/VIT) = A and
VITGR
MVT = A x VITGR x VIT
Where A
MVT
VIT
VITGR
•
= Market price to value indicator relative to the growth rate of
value indicator (e.g., (P/E)/ EPS growth rate)
= Market value of target
= Value indicator for target (e.g., EPS)
= Projected growth rate in value indicator (e.g., EPS)1
Firms whose PEG ratios > 1 considered overvalued; PEG ratios < 1 considered
undervalued
1Valid
for VITGR > 0. For VITGR = 0 or < 0, firm value will not change or will decline.
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 percent and 9
percent, respectively. BES’ and CPS’ current earnings per share are $2.05 and $3.15,
respectively. The current share prices as of June 25, 2008 for BES is $31.48 and for CPX is $26.
The industry average price-to-earnings ratio and growth rate are 12.4 and 11 percent,
respectively. Based on this information, which firm is a more attractive takeover target (i.e., more
undervalued) as of the point in time the firms are being compared?
Industry average PEG ratio:1 (MVT/VIT) / VITGR = A = 12.4/11 = 1.1273
BES: Implied share price = A x VITGR x VIT = 1.1273 x 15 x $2.05 = $34.66
CPX: Implied share price = A x VITGR x VIT = 1.1273 x 9 x $3.15 = $31.96
Answer: The difference between the implied and actual share prices for BES and CPX is $3.18
(i.e., $34.66 - $31.48) and $5.96 ($31.96 - $26.00), respectively. CPX is more undervalued than
BES at that moment in time and therefore is the more attractive takeover target.
MVT = A x VITGR x VIT using an individual firm’s PEG ratio provides the firm’s current share price in period T, since this
formula is an identity. An industry average PEG ratio may be used to provide an estimate of the 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.
1Solving
Asset-Based Methods:
Tangible Book Value
• Tangible book value (TBV) = (total assets - total liabilities - goodwill)
MVT = (MVC / VICTBV) x VITTBV
Where
MVT
= Market value of target company T
MVC
= Market value of the comparable company C
VICTBV
= Tangible book value for comparable company C
VITTBV
= Tangible book value for target company T
(MVC/ICTBV) = Market value multiple for the comparable company
• Often used for valuing
– Financial services firms where tangible book value is primarily cash
or liquid assets
– Distribution firms where current assets constitute a large percentage
of total assets
Valuing Companies Using Asset Based Methods:
Practice Problem
Ingram Micro distributes information technology products worldwide. The firm’s share price on
8/21/08 was $19.30. Projected 5-year annual net income growth is 9.5% and the firm’s beta is
.89. Shareholders’ equity is $3.4 billion and goodwill is $.7 billion. Ingram has 172 million (.172
billion) shares outstanding. The following firms represent Ingram’s primary competitors. Note
that Synnex Corporation can be viewed as an outlier.
Market Value/
Tangible Book Value
Beta
Projected 5-Year Net
Income Growth Rate
(%)
Tech Data
.91
.90
11.6
Synnex Corporation
.70
.40
6.9
Avnet
1.01
1.09
12.1
Arrow
.93
.97
13.2
Based on this information, what is Ingram’s tangible book value per share (VIT)? What is the
appropriate industry average market value to tangible book value ratio (MVIND/VIIND)?
Estimate the implied market value per share for Ingram (MVT) using tangible book value as a
value indicator. Based on this analysis, is Ingram under-or-overvalued compared to it 8/21/08
share price?
Asset-Based Methods: Liquidation Method
• Value assets as if sold in an “orderly” fashion (e.g., 9-12
months) and deduct value of liabilities and expenses
associated with asset disposition.
• While varies with industry,
– Receivables often sold for 80-90% of book value
– Inventories might realize 80-90% of book book value
depending on degree of obsolescence and condition
– Equipment values vary widely depending on age and
condition and purpose (e.g., special purpose)
– Book value of land may understate market value
– Prepaid assets such as insurance can be liquidated with
a portion of the premium recovered.
Asset-Based Method: Break-Up Value
• Target viewed as series of independent operating units,
whose income, cash flow, and balance sheet statements
reflect intra-company sales, fully-allocated costs, and
operating liabilities specific to each unit
• After-tax cash flows are valued using market-based
multiples or discounted cash flows analysis to determine
operating unit’s estimated enterprise value
• The unit’s equity value is determined by deducting
operating/non-operating liabilities from estimated
enterprise value
• Aggregate equity value of the business is determined by
summing equity value of each operating unit less
unallocated liabilities held at corporate level (e.g., debt)
and break-up costs (e.g., accounting and investment
banking fees)
Replacement Cost Method
• All target operating assets are assigned a value
based on what it would cost to replace them.
• Each asset is treated as if no additional value is
created by operating the assets as part of a
going concern.
• Each asset’s value is summed to determine the
aggregate value of the business.
• This approach is limited if the firm is highly
profitable (suggesting a high going concern
value) or if many of the firm’s assets are
intangible.
Weighted Average Valuation Method
An analyst has estimated the value of a
company using multiple valuation
methodologies. The discounted
cash flow value is $220 million,
comparable recent transactions’
value is $234 million, the
comparable company average P/Ebased value is $224 million and the
firm’s break-up value is $200 million.
The purchase price paid for the
recent comparable transaction
included a 20% premium. The
analyst has greater confidence in
certain methodologies than others.
Estimate the weighted average
value of the firm using all valuation
methodologies and the weights or
relative importance the analyst gives
to each methodology.
1Note
Estimated
Value ($M)1
Relative
Weight
Weighted
Avg. ($M)
264 (DCF
Method)
.30
79.2
234 (Recent
Transactions
Method)
.40
93.6
268.8
(Comparable
Co. P/E
Method)
.20
53.8
240 (Breakup Value
Method)
.10
24.0
1.00
250.6
that the DCF, P/E-based (comparable company), and break-up values were increased by 1.2 to reflect the 20% premium
reflected in the recent comparable transactions estimate.
Real Options as Applied to M&As
• Real options refer to management’s
ability to adopt and later revise corporate
investment decisions (e.g., acquisitions)
• Options to expand (i.e., accelerate
investment)
– Acquirer accelerates investment in
target after acquisition completed due
to better than anticipated
performance of the target
• Options to delay (i.e., postpone timing of
initial investment)
– Acquirer delays completion of
acquisition until a patent pending
receives approval
• Options to abandon (i.e., divest or
liquidate initial investment)
– Acquirer divests target firm due to
underperformance and recovers a
portion of its initial investment
Alternative Real Option
Valuation Methods
• Develop a decision tree for which the NPV of each “branch” represents
the value of alternative real options. The option’s value is equal to
difference between the NPV including the real option and the NPV
without the real option.
• Treat the real options as financial options and value using the BlackScholes method.
– Option to expand or delay are valued as call options and added to
the NPV of the investment without the option.
– Option to abandon is valued as a put option and added to the NPV
of the investment without the option.
Key Points: Total NPV = NPV Without Option + Option Value and
Option Value = Total NPV – NPV Without Option
Microsoft Real Options Decision Tree in 2008 Attempted
Takeover of Yahoo
Option to expand
contingent on
successful
Integration of Yahoo
& MSN
Base Case:
Microsoft Offers
To Buy All
Yahoo Shares in 2008
Option to postpone
contingent on
Yahoo’s rejection
of offer
Embedded Options
Purchase Yahoo online
search only. Buy
remaining businesses later.
Enter long-term search
partnership.
Implemented in 2010.
Offer revised price for
all of Yahoo if
circumstances change
Option to abandon
contingent on
failure to integrate
Yahoo & MSN
Spin off combined Yahoo and
MSN to Microsoft
shareholders
Divest combined Yahoo & MSN.
Use proceeds to pay dividend
or buy back stock.
Microsoft & Yahoo Transaction Outcome
• 2008 offer price for all of Yahoo = $38 per share
• Offer rejected by Jerry Yang (founder) and board of
directors
• Microsoft withdraws offer and Yahoo share price
drops to $16 per share
• Jerry Yang later fired
• Microsoft and Yahoo agree to online search
partnership in 2010 in which MSN and Yahoo
combine search businesses
Discussion Questions
1.
2.
3.
4.
5.
Does the application of the comparable companies valuation method
require the addition of an acquisition premium? Why or why not?
Which is generally considered more accurate: the comparable
companies or recent transactions method? Explain your answer.
What key assumptions are implicit in the comparable companies
valuation method? The recent comparable transactions method?
Explain the primary differences between the income (discounted cash
flow), market-based, and asset-oriented valuation methods?
Under what circumstances might it be more appropriate to use
relative-valuation methods rather than the DCF approach? Be specific.
Things to Remember…
• Alternatives to discounted cash flow analysis include the following:
– Market based methods
• Comparable companies
• Recent transactions
• Same or comparable industries
– Asset based methods
• Tangible book value
• Liquidation value
• Break-up value
– Replacement cost method
– Weighted average method
• Firm value must be adjusted for both non-operating assets and
liabilities.
• Real options should be considered in M&A valuation when clearly
identifiable and when would add significantly to investment’s value