1
Vienna MBA
Mergers & Acquisitions
Instructor: Adlai Fisher
About the Course
• Mergers, acquisitions, and restructurings
– offer a lens into a variety of financial management
practices at a critical time in the life of a corporation
– Managers make decisions with guidance from
• Relevant financial theory
• Advanced quantitative methods
• Careful study of previous business decisions and
outcomes
M&A Foundations
• Successful transactions require managers to have solid
understanding of a variety of finance topics and tools
–
–
–
–
–
–
–
–
–
–
–
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Valuation
Capital structure
Financial distress
Financial statement analysis
Working capital management
Securities markets
Securities issuance
Agency theory
Corporate governance
Executive compensation
Real and financial derivatives
Etc.
Course Outline
4
• 1: Introduction and M&A Overview, Valuation
– Theoretical frameworks, historical and international perspective, participants
– DCF, multiples, due diligence, wealth effects
– Case: Ducati (Instructor presented)
• 2: Transaction Structuring
– Merger legal process, payment method, deal protection, accounting, tax, antitrust
– Case: Seagate
• 3: Hostile Transactions
– Takeover strategies and defenses, duties of directors
– Case: Vodafone
An Example of M&A: MSFT bids for Yahoo
$44 Billion
Feb 1, 2008
Yahoo
MSFT
62% premium
7%
47%
The combination also offers an increasingly exciting set of
solutions for consumers, publishers and advertisers while
becoming better positioned to compete in the online
services market
This odd and opportunistic alliance of Microsoft has
anything but the interests of Yahoo!'s stockholders in
mind
5
Vienna MBA
Mergers and Acquisitions
M&A Overview: Motives
and History
6
Overview Outline
• M&A objectives, creating shareholder value
• Three theoretical frameworks
• Historical and international perspective
• Current trends
• Participants
• Deal taxonomies
7
M&A and Shareholder Value
• Creating shareholder value is the dominant paradigm
for thinking about the role of the firm
– Ways of increasing shareholder value
• Operations
• Finance
• Strategy
8
The Corporate Objective Reconsidered
• Legal framework
– U.S.: Shareholder value is explicitly the objective
– Canada: CBCA expresses goal of maximizing value of the firm (not
necessarily the same)
– Europe: broad set of explicit stakeholders
– Other areas: China?
• In practice
– Managers may have very different incentives than shareholders
(Microsoft / Yahoo)
– Other stakeholders can influence decisions
• Employees, trade groups, government, consumers, etc.
• E.g., China Petroleum / Unocal
• Inference: Don’t take the corporate objective for granted, likely
many interests at stake
9
Creating Value
• An acquisition is only one among many possible
tactics or strategies
• To create value: focus on areas of expertise or
special competencies  competitive advantage
• An acquisition may be
1. a well-planned way of achieving a corporate goal
(strategic buyer), and/or
2. it may be opportunistic (financial buyer )
• An acquisition generally should not be considered a
corporate goal in and of itself
10
Bidding Strategies / Winner’s Curse
• Common values auction: all participants get a noisy
signal Si = V + ei of true value V
– Example: Put cash in envelope, and sealed bid auction to
class. Everyone gets a noisy signal as described above.
– What is the equilibrium strategy?
– What happens if everyone bids their signal?
• Private values auction: Each individual has a
different true value Vi and receives signal Si = Vi + ei
– Is the winner’s curse larger or smaller than in common
values auction?
• How does this relate to the bidding strategies of
financial and strategic buyers?
11
Three frameworks that help us to understand M&A
#1 – Microeconomics
#2 – Principal – Agent Theory
#3 – Financial engineering
12
Three Theoretical Frameworks
#1 – Microeconomics
• Industry structure is an equilibrium involving
– Technology
– Legal and regulatory environment
– Macroeconomy
• Dynamics
– Slow adjustment: internal investment / disinvestment
– Rapid adjustment: M&A becomes more important
13
M&A Frameworks
#2 – Principal – Agent Theory
• Separation of ownership and management
creates agency costs
• When do goals of managers and shareholders
differ?
– Mature firm in declining industry
– Significant free cash flow (Jensen’s FCF Hypothesis)
• Underperforming firms become takeover targets
– LBO’s, MBO’s, and Hostile takeovers
– Example: T. Boone Pickens and Mesa Petroleum
14
M&A Frameworks
#3 – Financial engineering
• Unlocking value by changing corporate or
financial structure
– Tax motives (Profitable firm buys company
with NOLs)
– Input hedging (e.g., Dupont Conoco)
– Risk synergies (debt capacity)
15
Example: Coca-Cola acquires Huiyuan Juice Corp
$2.4 Billion in Cash
Sep 3, 2008
Huiyuan
Coca
3 times
Huiyuan’s price
0.2%
167%
This acquisition will deliver value to our shareholders
and provide a unique opportunity to strengthen our
business in China.
17%
4%
Notable Deals…
•
•
•
•
•
•
Magna Int. / Opel, GM division (55% stake, Sept 2009)
Kraft / Cadbury ($17 billion, Sept 2009)
Microsoft intended acquisition to Yahoo ($44 billion, 2008)
Murdoch’s News Corporation/Dow Jones ($5 billion, 2007)
Google / YouTube ($1.65 billion in shares, 2006)
Barrick / Placer ($10.4 billion, hostile then friendly cash and
share tender, 2006)
• Sanofi / Aventis ($65 billion, 2004)
• Cingular / AT&T Wireless ($41 billion cash, 2004)
• JP Morgan / Banc One ($58 billion, 2004)
Historical Perspective
Merger waves
– 1895-1904
– 1922-1929
– 1940-1947
– 1965-1969
– 1980’s
– 1993-2000
– 2002-2006
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Historical Perspective
1895-1904
• Economy
– Rapid economic expansion
– Recession begins in 1903
• Technology
– Transcontinental railroads permit national markets
– Electricity
• Regulatory environment
– Permissive
– Supreme Court decision in 1903 begins enforcement
of Sherman Act
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Mergers wave around 1900
Number of Mergers
1400
1200
1000
800
600
400
200
0
1897
1898
1899
Source: Mergerstat Review 1989
1900
1901
1902
1903
1904
20
Historical Perspective
1895-1904 (cont.)
• Mergers
– Mostly horizontal: characterized as “merger
for monopoly”
– Concentrated within heavy manufacturing
– Forms U.S. Steel, DuPont, Standard Oil, GE,
Kodak
– Activity peaks in 1901: result of failure of
some merge
21
Historical Perspective
1922-29
• Economy
– Rapid economic expansion
– Ends around time of crash
• Technology
– Automobiles increase consumer mobility, local
distribution
– Radio permits product differentiation and
development of national brands
• Regulatory environment
– Stricter enforcement against monopolies
22
Historical Perspective
1922-29 (cont.)
• Mergers
– Characterized as “merger for oligopoly”
– Also vertical mergers, product extension,
geographic extension
– Concentrated in public utilities, banking, food
processing, chemicals, mining, retailing
– IBM, General Foods, Allied Chemical
23
Historical Perspective
1940-1947
• Rapid growth of the economy
• Less technological change, smaller
merger wave
• Wartime price controls lead to vertical
mergers
24
Historical Perspective
1960’s Conglomerate Merger Wave
• Economy
– Rapid economic expansion
– Recession begins in 1971
• Regulatory
– Strict antitrust enforcement
• Mergers
– At peak in 1967-1968, only 17% of mergers are horizontal or
vertical
– Product extension, 60%
– Pure conglomerate, 23% (35% of assets)
– Roll-ups of many small-medium firms
25
Historical Perspective
1960’s Conglomerate Merger Wave (cont.)
• Other possible factors
– Theory that these were
defensive/diversification driven: management
entrenchment
– Impact of management science
– EPS bootstrapping
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Historical Perspective
Example: Ling-Temco-Vought (LTV)
• Founder James Ling begins with $2000 investment in
electronics in 1956
• Acquisitions:
–
–
–
–
–
–
–
–
American Microwave
J & L Steel
Wilson – sporting goods, meat packing, and pharmaceuticals
Braniff Air – commercial airline
Temco, Vought – military aircraft
National Car Rental
Banks, insurance companies
Altec sound systems
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Historical Perspective
1980’s
• Economy
– Expansion begins in earnest in 1984
– Recession begins in 1990
• Financial innovation
– Junk bonds, LBO’s, MBO’s
• M&A
– Characterized as “undoing the conglomerate merger
wave”
– Innovation in hostile takeover strategies
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Historical Perspective
1980’s (cont.)
• Sharp decline in 1990-1992
– Recession
– Adverse court decisions, state anti-takeover
amendments
– Failure of junk-bond market and many
leveraged transactions
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Historical Perspective 1960
Number of US Mergers
7000
6000
5000
4000
3000
2000
1000
0
1963
1964
1965
1966
Source: Houlihan Lokey Howard & Zukin
1967
1968
1969
1970
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Decline of mergers1970
Number of US Mergers
7000
6000
5000
4000
3000
2000
1000
0
1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980
Source: Mergerstat Review 1989
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Mergers from 1980-2006
$Millions
U.S. M&A
2,000,000
1,800,000
1,600,000
1,400,000
1,200,000
1,000,000
800,000
600,000
400,000
200,000
0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006
Source: Thompson Securities Financial Data (SDC)
32
Historical Perspective
1993-2000
• Economy in rapid economic expansion
• Technology
– Telecommunications
– Semiconductors, Software
– Networking, the internet
• Regulatory environment
– Anti-trust policy changing because of convergence of previously
segmented markets
– Technological convergence
– Geographic convergence: international
– Takeover defenses strengthened
– Loosening of restrictions in broadcasting, banking, insurance,
utilities
33
Historical Perspective
1993-2000 (cont.)
• M&A
– Strategic mergers, many across previously
segmented but converging businesses
– Most are friendly, increasing stock financing
– Divestitures to increase focus
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Historical Perspective
2002-2006
• M&As more successful this time around?
• Potential explanations:
– Deal management and governance: “Senior
management today are much more attuned to
shareholder opinions, and are more accountable for
demonstrating shareholder value …”
– Better due diligence: “… companies have learned
from mistakes that were made in the last two merger
waves…”
– Financial synergies and people integration: “Cultural
synergies are taken much more seriously than they
were in the previous two merger waves.”
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Historical Perspective: Summary
All of the U.S. merger waves are
• Associated with economic expansion, and end with recessions
• Greatly affected by the regulatory environment
– 1895-1904: Merger for monopoly
– 1922-1929: Merger for oligopoly
– 1960’s: Conglomerate
– 1993-2000: interstate banking, global industrial consolidation
• Greatly affected by technology
– 1895-1904: Transcontinental railroads permit concentration of
heavy manufacturing industries
– 1922-1929: Radio permits product differentiation and
development of national brands
– 1993-2000: telecommunications, semiconductors, the internet
• Financial innovation also plays a role
– LBO’s, junk bonds, and the merger wave of the 1980’s: Undoing
the conglomerate merger wave
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International Perspective
Global M&A Volume in Trillion
4
3.5
3
2.5
2
1.5
1
0.5
0
1998
1999
2000
2001
2002
2003
2004
2005
2006
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International Perspective
• 1999 Data: Dramatic growth in European, crossborder, and Far Eastern M&A volume
–
–
–
–
–
North America: $1.5 trillion
Europe: $1.1 trillion
Asia: $232 billion
South America: $21 billion
Cross border
•
•
•
•
•
North America – Europe: $350 billion
North America – Asia: $54 billion
Europe – South America: $36 billion
Europe – Asia: $31 billion
North America – South America: $18 billion
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European Merger Wage
$ Millions
2,000,000
1,500,000
1,000,000
500,000
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006
Source: Thompson Securities Financial Data (SDC)
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Australia Merger Wage
200,000
150,000
$ Millions
100,000
50,000
1984
1987
1990
1993
1996
1999
2002
2005
Source: Thompson Securities Financial Data (SDC)
40
China Merger Wage
$ Millions
200,000
150,000
100,000
50,000
1984 1987 1990 1993 1996 1999 2002 2005
Source: Thompson Securities Financial Data (SDC)
41
Japan Merger Wage
$ Millions
200,000
150,000
100,000
50,000
1984
1987
1990
1993
1996
1999
2002
2005
Source: Thompson Securities Financial Data (SDC)
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Key Elements of a Successful Deal
The shocking truth: most acquisitions hurt
shareholder value!
– Search for synergies
– Added hurdle of takeover premium
We can generally think of a deal as being
composed of four stages:
–
–
–
–
Strategy
Valuation
Mechanics
Implementation & integration
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The Principal Participants
Buyer / seller
–
–
–
–
Board of Directors
Managers
Shareholders
Employees
Advisors
–
–
–
–
Bankers
Lawyers
Accountants
Consultants
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The Principal Participants (cont.)
Regulators
– Antitrust
– Industry regulators
– Securities regulators
Others
– Risk arbitrageurs
– Short term financiers
All of these parties have separate interests…
Inference: Need for leadership and orchestration
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Deal Taxonomies
By economic motivation
– Synergies in either costs or revenues
– Market power
– Wealth transfers from / to shareholders,
debtholders, employees, the government
– M&A as a solution to agency problems
– M&A as a manifestation of agency problems –
empire building
– The winner’s curse and overpayment
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Types of Deals
Takeover
–
The transfer of control from one ownership group to another.
Acquisition
–
The purchase of one firm or set of assets by another
Merger
–
–
–
The combination of two firms into a new legal entity
A new company is created
Both sets of shareholders have to approve the transaction.
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Types of Transactions
How the Deal is Financed
Cash Transaction
– The receipt of cash for shares by
shareholders in the target company.
Share Transaction
– The offer by an acquiring company of shares
or a combination of cash and shares to the
target company’s shareholders.
15 - 48
Financial Data Source
1.
M&A: Thomson ONE Banker / SDC Platinum
(http://toby.library.ubc.ca/resources/infopage.cfm?id=1423 )
2.
Financial statement and stock price:
Yahoo Finance (http://finance.yahoo.com/ )
Google Finance (http://finance.google.com/finance )
3.
Corporate News
Factiva (http://toby.library.ubc.ca/resources/infopage.cfm?id=970 )
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Vienna MBA
Mergers & Acquisitions
Valuation: DCF Methods
50
Outline
• DCF valuation techniques
– Weighted Average Cost of Capital (WACC)
– Adjusted Present Value (APV)
• Capital Cash Flows (CCF)
– Flow to Equity (FTE)
51
Weighted Average Cost of Capital

UCFt
NPV  
t
(1

WACC
)
t 0
 UCF: Unlevered cash flow
UCF  EBIT  Tax  Depreciation  Capex  WorkingCapital
 WACC: After-tax weighted average cost of capital
WACC  wB rB (1  T )  wS rS
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Adjusted Present Value (APV)
APV  NPVU  NPVF

UCFt
NPVU  
t
(1

r
)
t 0
0
•NPVU: NPV of unlevered firm
•r0: required return on unlevered
firm
InterestExpenset  Tc
NPVF  
t
(1

r
)
t 0
B

•NPVF: NPV of financing side
effects
•rB: required return on debt
• The NPVF formula above includes only interest tax shields
• Ideally, we would also like to capture other financing side effects (but
this is often difficult)
• cost of financial distress, financing subsidies, issuing cost
• Similar caveat applies to WACC
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Capital Cash Flow Method (CCF)
• You will sometimes hear a valuation method called capital
cash flows discussed (e.g., Yell)
• This is just an APV method, where instead of using rB to
discount the tax shield benefits of debt, use r0 to discount tax
shield benefits of debt.
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Flow to Equity (FTE)

LCFt
NPV  
t
(1

r
)
t 0
S
LCF :Levered cash flow
rS : Required rate of return on the levered equity
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Summary of the Methods
• All the three DCF methods are equivalent in theory
• In practice, some method may be easier, depending on
the situation
•WACC and FTE assume constant debt/equity ratio. For timevarying debt/equity ratio, discount rates change each period.
•APV uses r0, which does not depend on capital structure.
If debt/equity ratio is constant, then use WACC or FTE
If the dollar value of debt over time is known, then use APV
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Estimating rs
• The primary method of estimating the required return on
equity is to use the CAPM. We will focus on this.
• Other models can also be used, e.g., Fama-French,
conditional CAPM (time-varying loadings/risk-premia)
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Using the CAPM
E (rS )  rf   E[rM  rf ]
• Beta: Google finance, typically calculated from 1-5 year
market model regressions on monthly, weekly, or sometimes
daily data
• Risk-free rate: Intermediate or long-term government bond
rate, usually chosen to match duration of cash flows Google
finance
• The market risk premium: Estimated from medium (10-20
year) to long-run (80 year) averages of excess market returns
•Elaborations: conditioning variables, international data, structural breaks
•In practice, typically use values between 3.5% and 7%
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Cautions when using the CAPM to get rs
• Remember that any beta estimate from Google or your own
regression reflects the historical risk of the company’s equity
• Equity risk can be changed by altering the financial structure of the
company, or the asset mix
• Thus, if leverage is changing, or the assets are changing, need to
think carefully about how to use historical beta
• Example 1: You have a historical equity beta estimate, and
plan to use the same assets going forward, but with a different
capital structure.
•Delever to get asset beta, relever for new equity beta
•Example 2: You are changing the asset mix of the company,
or the way assets are used
•Find pure play comparables, delever to get asset betas, relever for your own
capital structure
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The All-equity cost of capital
Method 1: Use Modigliani-Miller Proposition II, with taxes
B (1  TC )
rs  r0 
(r0  rB )
S
Can use solver to obtain r0 or some algebra gives:
S
B (1  T )
r0 
rs 
rB
S  B(1  T )
S  B(1  T )
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MM Proposition II, no taxes
rs=r0+B/S(r0-rB)
r0
rWACC
rB
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MM Proposition II, with taxes
rs=r0+(B/S)(r0-rB)(1-T)
r0
rWACC
rB
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The All-equity cost of capital
Method 2: Use the levering and delevering formulas for betas,
and the CAPM
S
B(1  T )
0 
E 
D
S  B(1  T )
S  B(1  T )
S

 E (if  D  0)
S  B(1  T )
E (r0 )  rf   0 [ E (rM )  rf ]
Note: you will often see the beta levering/unlevering formula written without (1-T) anywhere.
This reflects an assumption that the riskiness of debt tax shields is equal to the risk of the
unlevered assets.
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Example
• Johnson and Johnson operate in several lines of business:
Pharmaceuticals, consumer products, and medical devices.
• To estimate the all-equity cost of capital for the medical devices
division, we need a comparable, i.e., a pure play in medical
devices (we should really have several).
• Data for Boston Scientific:
–
–
–
–
Equity beta = 0.98
Debt = $1.3b
Equity = $9.1b
Tax rate (T)= 20%
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Example (cont.)
• Compute Boston Scientific’s asset beta (assuming D = 0):
0  E
S
9.1
 0.98 
 0.88
S  D(1  T )
9.1  1.3(1  0.2)
• Let this be our estimate of the unlevered asset beta for the medical
devices business.
• Use CAPM to calculate the all-equity cost of capital for that business
(assuming 6% risk-free rate, 8% market risk premium):
r0 = 6% + 0.88 *8% = 13.04%
65
Which WACC should we use, the acquirer or the target?
• Generally, we use the target WACC.
 We should adjust the discount rate based on the riskiness of their
investment.
 The riskiness of an acquisition depends upon the characteristics of
the target, hence, we use target WACC.
• The first exception: the target will be restructured
 If the acquirer plans to change the operations of the target and this
would have a foreseeable effect on the riskiness of the target cash
flows, then we would want to consider this.
• The second exception: the target is private
 No market data available for WACC.
 Use the WACC of a publicly traded company that is most similar to
the target.
 Use the acquirer WACC as a proxy
66
Whose capital structure to use, the acquirer or the target?
• Generally, we use the target capital structure.
 Optimal capital structure is determined by the riskiness of the
underlying assets
 It is not typically affected by a change of control.
• Again, one exception: the target will be restructured
 Acquirer projects major changes that will predictably affect the
riskiness of the target cash flows.
• Another exception: risk synergies
 Two firm’s risk cancels each other.
 This is a minor issue
67
Market values or book values to weight debt/equity?
• The weightings should be based on market values of
both debt and equity.
• Because market and book value tend not to be very
different for debt, the book value of debt is often used in
practice.
68
Summary
• Three DCF methods
• If debt-equity ratio is stable over time, use WACC or FTE
• If not, use APV (for LBO, use APV)
69
Appendix: Valuation Example
70
Singer Company Valuation Example
Consider valuation of Singer company for sale for $475,000
Cash sales: $500,000 per year for indefinite future
Cash costs: 72% of sales
Corporate tax rate: 34%
Cost of capital if unlevered(r0 ): 20%
Interest Rate(rB ): 10%
Target debt to equity ratio: 1/3
Calculate value using
•WACC
•APV
•FTE
71
Singer Company WACC Valuation
Consider valuation of Singer company for sale for $475,000
Cash sales: $500,000 per year for indefinite future
Cash costs: 72% of sales
Corporate tax rate: 34%
Cost of capital if unlevered(r0 ): 20%
Interest Rate(rB ): 10%
Target debt to equity ratio: 1/3
UCF  (Cash Sales  Cash Cost )(1  Tax Rate )  92, 400
rS  r0  ( B / S )(1  TC )(r0  rB )  22.2%
rWACC  (3 / 4)  0.222  (1/ 4)  0.1 0.66  18.3%
NPV  92, 400 / 0.183  475, 000  $29,918
72
Singer Company APV Valuation
Consider valuation of Singer company for sale for $475,000
Cash sales: $500,000 per year for indefinite future
Cash costs: 72% of sales
Corporate tax rate: 34%
Cost of capital if unlevered(r0 ): 20%
Interest Rate(rB ): 10%
Debt Financing (B): 126,229.5
Present Value of Unlevered Firm(Vu )  UCF / r0  462, 000
NPVU  Vu  475, 000  13, 000
NPVF  B  rB  TC / rB  B  TC  $42,918
APV  NPVU  NPVF  $29,918
73
Singer Company FTE Valuation
Consider valuation of Singer company for sale for $475,000
Cash sales: $500,000 per year for indefinite future
Cash costs: 72% of sales
Corporate tax rate: 34%
Cost of capital if unlevered(r0 ): 20%
Interest Rate(rB ): 10%
Debt Financing (B): 126,229.5
LCF  (Cash Sales  Cash Cost  Interest Expense )(1  Tax Rate)  84,068.85
PV  LCF / rs  84, 068.85 / 0.222  378, 688.50
Purchase cost to equity  475, 000  126, 229.5  348, 770.5
NPV  PV  348, 770.5  $29,918
74
Vienna MBA
Mergers & Acquisitions
Valuation II: Multiples Valuation
Multiples Valuation: Introduction
•
Basic idea: use prices of a peer group to build up an estimate
of value for the firm you are analyzing (law-of-one-price)
•
Outline of typical steps:
1. Choose a relevant peer group (e.g., firms in an industry)
2. Propose a quantity (e.g., EBITDA) that you believe correlates to value
(e.g., EV) among firms in the peer group
3. Calculate the corresponding ratio (e.g., λi=EVi/EBITDAi) for all
observations i in the peer group
N
 /N
4. Designate the average multiple:  
i 1 i
5. Apply this multiple to the firm you are analyzing to estimate its value:

Vˆ0   * EBITDA0
Multiples Valuation: Theory
•
You are already familiar with the theory behind some
important multiples
•
E.g., the price-dividend (P/D) ratio:
–
For a firm i with constant growth of dividends:
Pi ,t 
–
Di ,t 1
ri , stock  g D
Gordon Growth Formula
Hence:
(1  g D )

Di ,t ri ,stock  g D
Pi ,t
Thus, the P/D ratio is driven by equity risk (rs) and the growth rate (gD)
P/D Ratio Example
•
For different values of rs and gD:
rs
gD
10% 0%
10% 2.5%
10% 5%
15% 0%
15% 2.5%
15% 5%
20% 0%
20% 2.5%
20% 5%
P/D
10.0
13.7
21.0
6.7
8.2
10.5
5.0
5.9
7.0
• Higher risk (rs) reduces the P/D ratio
• Higher growth (gD) increases the P/D ratio
The P/E Multiple
• Note That
P0
P
P
D
 0 * 1  0 * Payout Ratio1
E1
D1 E1
D1
• Following the Gordon Growth formula again:
P0
D1
Payout Ratio1
1

*

E1
rs  g D E1
rs  g D
• Again shows:
– The higher the expected growth rate, g, the higher the P/E
– The higher the required rate of return, r, the lower the P/E
– Changing the payout ratio has two effects: Direct effect in numerator, and
indirect effect on g in denominator, which effect dominates depends on
the investment opportunities of firm
• Good investment opportunities: High plowback (reducing payout) should
maximize P/E
• Poor investment opportunities: High payout should maximize P/E
Intuition for P/E
• The ratio tells you how many times projected annual earnings (per
share) the share is currently trading
P0  Estimated EPS1  Justified P/E ratio
P0
 EPS1 
E1
• If you buy a company that is trading 10 times projected earnings, it
may take 10 years of those earnings to recover your investment.
• If you buy a company trading 100 times projected earnings, it may
take 100 years of those earnings to simply recover your investment
(excluding time value on your investment).
The S&P/TSX Composite P/E
Earnings volatility creates wide variations in P/Es associated with the business
cycle.
P/E Ratios in the Forest Industry
Company
Price
2006 EPS
Forecast EPS
P/E
P/E Forecast
Abitibi
Canfor
Cascades
Canfor Pulp
Catalyst
Fraser Papers
International
Mercer
Norbord
PRT
SFK Pulp
Tembec
2.72
11.13
11.54
11.56
3.22
7.01
6.6
9.69
8.41
11.2
4.14
1.43
-0.30
-0.27
0.71
1.38
-0.07
-1.35
0.26
-0.07
0.74
0.69
0.64
-2.00
0.12
0.47
0.60
1.20
0.03
-0.41
0.53
0.14
0.40
0.70
0.82
-1.11
nm
nm
16.25
8.38
nm
nm
25.38
nm
10.24
16.23
6.47
nm
22.67
23.68
19.23
9.63
nm
nm
12.45
54.35
18.95
16.00
5.05
nm
P/E is uninformative when company has negative (or small) earnings
Other Ratios Motivated by Theory
•
The enterprise value (EV or V) to free cash flow (FCF=UCF)
ratio
EVi ,t 
–
UCFi ,t 1
ri ,WACC  gUCF
Hence:
(1  gUCF )

UCFi ,t ri ,WACC  gUCF
EVi ,t
EV/FCF is driven by firm risk (rWACC) and the growth rate (gFCF)
Other Ratios Motivated by Theory
•
The enterprise value (EV) to capital cash flow (CCF) ratio
EVi ,t 
–
CCFi ,t 1
ri ,0  gCCF
Hence:
(1  gCCF )

CCFi ,t ri ,0  gCCF
EVi ,t
EV/CCF is driven by unlevered firm risk (r0) and the growth rate (gCCF)
Varieties of Multiples: Numerator and Denominator
•
In the numerator:
–
–
•
Enterprise value, denoted V or EV
Equity value, either per share (P) or total market cap (S)
In the denominator:
–
–
–
–
–
–
–
–
–
–
–
Dividends (for P or S)
Aggregate Dividends plus coupon payments (for EV)
FCF=UCF (for EV)
CCF (for EV)
LCF (per share for P, aggregate for S)
EBIT (for EV)
EBITDA (for EV)
Sales/Revenues (for EV)
# of customers, web site hits, # of employees, R&D spending, … (EV)
Book value (of assets for EV, of equity for S, of equity per share for P)
…
Choosing the Numerator (P or EV)
•
From theory we know that equity multiples (P) will be
determined roughly by
–
–
•
Equity risk rS=r0+(B/S)(r0-rB)(1-T)
Growth rate of equity cash flows
Includes business risk (r0) and
financial risk (determined by B/S)
Enterprise value multiples (EV) are determined roughly by:
–
–
Firm risk (r0 or rWACC)
Growth rate of FCF, CCF
Much less sensitive to capital structure:
r0 invariant; rWACC has only tax impacts
Using EV in the numerator has an important advantage:
EV ratios are not as sensitive to capital structure and corresponding
variations in equity risk
Choosing the Denominator
•
With EV in the numerator, theory encourages us to look at
FCF or CCF
•
Many other variants that focus on income flows to all
claimants
–
–
–
EV/EBIT, EV/EBITDA, EV/(Net Income + interest), etc.
Accounting adjustments can be motivated if they help to smooth noise
in cash flows, providing more accuracy
Other attempts to smooth noise include taking an average of cash
flows, EBIT, or EBITDA over multiple quarters / years
EV/Sales (or P/S)
Usually driven by industry that is not currently profitable
(e.g., internet companies in late 90’s)
Advantages
– Sales are less sensitive to accounting decisions and are never negative
– Not as volatile as earnings
– Provides information about corporate decisions such as pricing
Disadvantage
– Does not include information about expenses and profit margins which
are key determinants of corporate performance
Other multiples based on profit potential (sometimes
distant):
•
customers, geographic coverage, web site hits, etc.
EV/Assets
•
The other main type of denominator is based on assets
•
E.g., the ratio EV/(Book Value of Assets) is closely related to a
theoretically motivated measure called Tobin’s Q
Market Value of Assets (EV)
q
Replacement Cost of Assets
q provides a ratio describing value added by the firm
•
When Market/Book uses equity in the numerator and denominator, it is the
inverse of the B/M ratio in the Fama-French 3-factor model
Choosing the Peer Group
•
The first, and perhaps most important, step in multiples
valuation is choosing a peer group
•
Most commonly, peer group chosen by industry and country /
geography of primary business location
–
–
–
4 digit SIC codes, NAIC codes, Fama-French industry definitions,
Yahoo or Google stock screener industry definitions, etc.
Choose firms that are legitimately in a similar line of business, that one
would expect to have similar profit profiles and risk characteristics
If EV in numerator, not essential that peers have similar capital
structures; for equity multiples, capital structure is an important control.
Two Primary Variants
•
Trading Multiples: Common general purpose technique
–
–
–
–
•
Calculate multiples for peers based on the current trading values of
equity and, where available, debt (otherwise can use book for debt)
Typically require that peers are publically traded so that market value of
equity can be obtained
Discounts sometimes applied for illiquidity if the firm being valued is not
publically traded.
Does not include a control premium
Transaction Multiples: Used in M&A settings
–
–
–
–
Based on relatively recent transactions involving purchases or
acquisitions of peer group firms
Peer group transactions may be public or private
Generally harder to find good peer comparisons, and sometimes the
transactions are older than we would like
Includes a control premium
Strengths and Weaknesses of Multiples Valuation
•
Strengths
–
–
•
Simple, easy to use, easy to understand
Incorporates current information on how the market values peer firms
Weaknesses
–
–
–
Multiples are based on relative valuation and are only accurate if the
market values other firms correctly
By contrast, DCF methods use absolute valuation, and do not rely on
the market’s valuations of peer firms
Paradox: if all investors use only relative valuation, then nothing ties
down the price level and the market becomes inefficient
•
Use of relative valuation methods is often cited as an important contributor
to speculative bubbles (internet bubble, housing bubble, etc.)
Choosing a Multiple to Use
•
For any industry/situation, there are often a number of
potential multiples one could use
–
•
EV/EBITDA, EV/FCF, EV/sales, EV/Assets, etc.
To compare accuracy of different multiples within peer group,
interpret multiples valuation as a restricted (zero intercept)
regression:
Combining Information in Different Multiples
•
Suppose we have several multiples that seem to work well
–
–
One ad hoc way to combine information is to calculate implied values
from each multiple, and average
A more systematic way to approach the problem is to run a multiple
regression, e.g.
EVi  a0  a1CCFi  a2 Assetsi  a3 R & Di   i
Obtain estimates of regression coefficients using peers, and apply these
coefficients to the corresponding variables for firm being analyzed:
Vˆ0  aˆ0  aˆ1CCF0  aˆ2 Assets0  aˆ3 R & D0
Need to check the correlation of your regressors in first regression and collinearity diagnostics if two or
more are very closely related.
Which to Use, DCF or Multiples?
Often, both are valuable
–
–
Intuitively, DCF more accurate for projects with easy to forecast
cash flows (e.g., infrastructure projects), and where the purchase
will be buy and hold
Multiples may tend to be more often used when cash flows are
difficult to predict, and the asset will be sold at current market
valuations (e.g., IPO)
Appendix
Example
Consider the following target firm
Sales
$10 M
EBITDA
$ 3.3 M
EBIT
$2.5 M
Net Income
$1M
# of shares
$0.5 M
Debt
$5 M
Equity
$5 M
Market Value of Equity
$15 M
Ratio
T1
T1 5-Yr. Avg.
Ind. Avg.
P/E
15 X
14.5
16.5
Value/EBIT
8X
5.5
7.5
Value/EBITDA
6.06
4.8
6
P/Sales
1.5X
1.35
1.6
P/Book
3X
3
3.2
Example
Using the industry average as the justifiable multiples
P/E
P/E * Net Income
16.5 *1M= 16.5 M
V/EBIT
V/EBIT * EBIT – Debt
7.5*2.5 – 5 = 13.75 M
V/EBITDA
V/EBITDA *EBITDA–Debt
6*3.3－5=14.8 M
P/Sales
P/Sales * Sales
1.6*10=16 M
P/Book
P/B*Book Value
3.2*5=16 M
Using the 5 Yr. average as the justifiable multiples
P/E
P/E * Net Income
14.5 *1M= 14.5 M
V/EBIT
V/EBIT * EBIT – Debt
6.5*2.5 – 5 = 11.25 M
V/EBITDA
V/EBITDA *EBITDA–Debt
4.8*3.3－5=10.8 M
P/Sales
P/Sales * Sales
1.35*10=13.5 M
P/Book
P/B*Book Value
3*5=15 M
Multiples Using Number of Employees
This sample used for all plots in
this file is all Compustat firms in
2007. Each dot represents a firm.
The regression line is restricted to
have an intercept of zero.
Multiples Valuation Using Sales
Multiples Valuation Using EBIT
Multiples Valuation Using EBITDA
Multiples Valuation Using Book Value of Assets
Cross-Industry Comparison of R2 from Regressions of EV
on other variables
# of
Employees
Sales
EBIT
EBITDA
Assets
Manufactu
ring
0.42
0.67
0.67
0.70
0.72
Mining
0.16
0.87
0.88
0.86
0.79
Retail
0.90
0.92
0.97
0.97
0.94
Info. Tech.
0.54
0.61
0.48
0.35
0.58
Finance
and
Insurance
0.82
0.84
0.66
0.68
0.73
This table reports R2 from univariate regressions of enterprise value (EV) on each of the variables listed in the column headings. The initial sample
is all Compustat firms in the 2007 data, and in each row the sample is restricted only to firms in that industry.
Cross-Industry Comparison: Regression Coefficient
Manufacturing
Mining
Retail
Info. Tech.
Finance and
Insurance
# of
Employees
Sales
EBIT
EBITDA
Assets
545.7
559
106
663.3
899
1.05
2.44
0.57
2.11
1.34
7.53
6.99
10.20
10.25
2.86
5.95
5.35
7.90
5.22
2.81
1.13
1.10
1.26
0.85
0.09
This table reports the regression coefficients from univariate regressions of enterprise value
(EV) on each of the variables listed in the column headings. The initial sample is all
Compustat firms in the 2007 data, and in each row the sample is restricted only to firms in
that industry.
Vienna MBA
Mergers & Acquisitions
M&A Wealth Effects
106
Overview
• Large literature in finance studying the wealth
and performance effects of M&A activity
– E.g., Event Studies
– Findings: Basic Wealth Effects in M&A
• The Market Timing Hypothesis and Stock Market
Driven Acquisitions
• Extras
107
Three approaches to measure M&A profitability
1. Event studies (most used in finance)
2. Accounting studies
3. Surveys of executives ( seldom used in
finance)
108
Procedures of event study
1. Identify the event of interest. (e.g., M&A, CEO turnover)
2. Define the event period? (e.g., -1 days and +1 day)
3. Compute the real stock return
4. Measure “normal” return using asset pricing model
(CAPM, APT, Fama-French, etc)
5. Abnormal return= real return – “normal” return
6. Sum up abnormal return to get cumulative abnormal
returns
Example of an event study
Bank of
America
$50 Billion in Stock
Merrill
Lynch
Sep. 15, 2008
Date
Rm
(S&P500)
16-Sep
15-Sep
12-Sep
1.75%
-4.71%
0.21%
R (BA)
11.30%
-21.31%
2.06%
AR(BA)=
R(BA)-Rm
R (ML)
9.55%
-16.60%
1.84%
AR( ML)=
R(ML)-Rm
30.01%
0.06%
-12.25%
28.26%
4.77%
-12.46%
Firm
Accumulative abnormal
returns (CAR3)
MV Equity
Dollar
Gain/Loss
BM
-7.95%
$ 155 Billion
－$12.3 Billion
ML
17.8%
$ 37 billion
+$6.6 Billion
110
Assumptions for event studies
• Event is unanticipated
– Abnormal returns are result of reaction
• No confounding effects
– Eliminate other events
• Markets are efficient (recall 3 forms of EMH hypothsis)
– Weak ( all past price and trading information)
– Semi-strong (all publicly known and available information)
– Strong (both public and private information)
111
Event studies
Strengths:
• A relatively direct measure of value to
shareholders
• A forward-looking measure
Weaknesses:
• Requires strong assumptions
• Vulnerable to confounding events…
112
Findings: Wealth effects for Bidders
– Approximately zero returns to successful bidders
– Possibly higher return to bidders in tender offers
(+4%) than in mergers (+0%)
– Slightly positive in 60s (+5%) and 70s (+2%), and
slightly negative in 80s (-1%)
– Very negative during late 90s and early 2000s
113
Wealth effects: Targets
• Target shareholders gain
• Tender offer vs. merger
– Aggregate 30% abnormal return to targets in tender
offers
– 20% abnormal return to “targets” in mergers
114
Predictive Ability of CAR
• If negative bidder returns on
announcement
– Future divestiture is more likely
– The acquirer is more likely to become a target
itself
• Positive event returns produce the
opposite
115
Failed Transactions
• Both bidder and target have negative CAR after
unsuccessful tender offer
The market is suspicious of both
• Market’s initial reaction predict outcomes
– Targets of failed tender offers who are acquired within the next 60
days had the most positive initial announcement effects (50%
Market reacts most positively initially for
compared to 23% for others)
targets who are most attractive in general
• For unsuccessful bidders
– If the target is acquired by another buyer in first 180 days, negative
returns for initial bidder (CAR 0 to 180) are –8%
– If the target is not acquired by another firm, the CAR (0 to 180) for
the initial bidder is zero.
Suggests that the market believes there is a problem with the buyer when deal fails and
target is acquired by different firm
116
Financing
Higher abnormal returns for targets in cash
offers than stock offers
– information effect (bidders use cash when they are more
confident)
– Also possibly tax effect (higher premium may be needed since
cash transactions taxed immediately, stock not)
117
Timing
– Average time between announcement and
completion of acquisition is 66 days
– Twice as long for completion when securities
are involved as opposed to an all cash
transaction
118
Multiple bidders
– When multiple bidders arise
• Target CAR +26% on day 1, +45% to day 80
– For a single bidder
• Target CAR +26% on day 1, +26% to day 80
– Initial acquirer loses 2.4% when a second bid
is announced
119
Predictors of Hostile vs. Friendly Structure
• Insider ownership
– Tends to be low in targets that get hostile bids
– High in targets that get friendly bids
• Previous performance of target
– Below average in hostile deals
– Above average in friendly deals
120
Surveys of managers
• Bruner (2002) conducted his own survey.
According to the respondents:
• 37% of deals create value for the buyer
• 21% of deals achieve their strategic goals
121
An important caveat
• Impossible to empirically test if
stakeholders would have been better off if
no M&A activity; hence, full tests of value
of M&A activity are impossible.
122
So, does M&A pay? Summary of findings
• Target firms: significant positive returns
• Acquirer firms: no value creation (NPV=0), on average.
– IF Cash offer: zero or slightly positive returns
– IF stock offer: negative returns
• Note: acquirer is typically larger in size. Therefore %
effect of acquisition is smaller for acquirer, all else being
equal
• Combined Target and Acquirer:
– value is created, NPV > 0
123
II. Market Timing and Stock Mergers
Discussion based on Moeller, Schlingemann, and Stulz,
Journal of Finance (2005)…
124
Dollar Gain/Loss ($M) in M&A 1980-1997
20000
15000
10000
5000
0
-5000
Bidder Return
Synergy
Target Return
Source: Moeller, Schlingemann, Stulz, Journal of Finance (2005)
125
Dollar Gain/Loss ($M) in M&A 1998-2001
100000
50000
0
-50000
-100000
-150000
-200000
1998
1999
Bidder Return
Synergy
2000
2001
Target Return
Source: Moeller, Schlingemann, Stulz, Journal of Finance (2005)
126
Dollar Gain/Loss ($M) in M&A 1980-2001
100000
50000
0
-50000
-100000
-150000
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
-200000
Bidder Return
Synergy
Target Return
Source: Moeller, Schlingemann, Stulz, Journal of Finance (2005)
127
Puzzle
What drove such massive losses, purely agency costs?
128
Market timing
$6
Good performance
$4
Bad performance
$5
If manager has private information, in which situation should
she issue equity?
What is the stock market reaction?
Negative stock reaction when firms issue equity
Positive stock reaction when firms repurchase equity
129
Stock market driven acquisition
• Current MV= 100 shares × $10/share=$1000
Information
asymmetry
• Fundamental MV = 100 × $1/share=$100
• Manager issues equity of $200 to undertake acquisitions
No Learning
Issuing Price
Shares
Issued
10
200/10 =20
Price (Short 10
During merger,
term)
Full Learning
Partial Learning
1
5
200/1=200
200/5=40
1
5
(100+200)/300=1
(100+200)/140=2.1
negative bidder return
Price (Long
(100+200)/120=
Without merger, more negative bidder return
term)
2.5
130
Stock market driven acquisition
• Overvalued bidders use equity to acquire real assets from target
• Stock price of bidders go down during the merger
• But the merger still serves the interests of bidder shareholders,
because the bidder’s stock return would be more negative
without the merger.
• Most evident in the later 1990s (Internet bubble).
131
III. Extras
…
132
CARs for Successful and Unsuccessful Bidders
Full sample: 1,815 deals. 1,401 successfully (dotted line), and 414
Unsuccessful (dashed line). Period 1971-1991.
Source: Schwert, Journal of Financial Economics, (1996), Markup Pricing in M&A
A Refinement of Bidder Returns
Bidder CAR(-1,1) for deals in 1980 – 2005
Large and small are the upper and lower quartile of market cap at -42.
Source: Eckbo, Betton, and Thorburn, Handbook of Empirical Corporate Finance (2008)
Some Links
• Does M&A Pay? (NY Times)
• New Merger Wave?
– CNN
– NY Times
135