--------
Chapter 9
--------
Alternative Approaches to
Valuation
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 1
Introduction
• Valuation critical in M&As
• Framework essential to discipline
valuation estimates
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 2
Comparable Companies
Method
• Group of companies comparable with
respect to:
– Size
– Products
– Recent trends and future prospects
• Key ratios are calculated for each
company
• Key ratios are averaged for group
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 3
• Average ratios applied to absolute data
for company of interest
• Indicated market values obtained from
each ratio
• Valuation judgments are made
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 4
• Advantages
– Common sense approach
– Marketplace transactions are used
– Widely used in legal cases, fairness evaluation,
and opinions
– Used to value a company not publicly traded
• Limitations
– May be difficult to find companies that are
actually comparable by key criteria
– Ratios may differ widely for comparable
companies
– Different ratios may give widely different results
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 5
Comparable Transactions
Method
• Valuation based on companies involved in
the same kind of merger transactions
• Market value refers to transactions in a
completed deal
• More directly applicable than company
comparisons
• May be difficult to find truly similar
transactions within a relevant time frame
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 6
Spreadsheet Approach to
Valuation and Mergers
• Procedure
– Historical data for each element of balance
sheet, income statement, and cash flow
statement are presented — 7 to 10 years
– Detailed financial analysis is performed to
discover financial patterns
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 7
– Additional analysis
• Business economics of industry in which
company operates
• Company's competitive position
• Assessments of financial patterns, strategies,
and actions of competitors
– Based on analysis, relevant cash flows are
projected
– Procedures similar to capital budgeting
analysis
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 8
• Capital budgeting decisions
– Process of planning expenditures whose
returns extend over a period of time
– An acquisition is fundamentally a capital
budgeting problem: Mergers do not make
sense if buyer pays too much resulting in
negative NPVs
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 9
• Spreadsheet projections
– Provide great flexibility in projections
– Important to understand underlying growth
patterns
– NPV of acquisition obtained from sum of free
cash flows discounted at applicable cost of
capital
FCF
NPV  
where :
(1  k )
n
t
t 1
t
FCFt = free cash flows in period t = X t ( 1  T)  I t
X t  before - tax cash flows in period t
T = tax rate
I t  investment outlays in period t
k = cost of capital
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 10
• Advantages of spreadsheet approach
– Expressed in financial statements
– Any desired detail of individual balance
sheet or income statement accounts
– Flexibility and judgment in formulating
projections
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 11
• Disadvantages of spreadsheet approach
– Numbers used in projections may create
illusion that they are actual or correct numbers
– May lack link between projected numbers and
business logic
– May become highly complex
– Details may obscure important driving factors
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 12
Formula Approach
• No real distinction between spreadsheet
approach and formula approach
– Both use discounted cash flow analysis
– Spreadsheet approach expressed in form of
financial statements over period of time
– Formula approach summarizes same data in
compact form
– Formula approach helps focus on underlying
drivers of valuation
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 13
• Development of compact valuation
formulas
– Valuation necessarily requires forecasts
– Usually assumes systematic relations
between time periods, variables
• Key variables and relationships
– Revenues (Rt)
• Basic driver of a firm's value
• Market value to revenue multiples usually
calculated for comparing values of firm in same
industry
• Main approach to valuing Internet stocks
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 14
– Growth rate (g)
• Defined as rate of change in revenues
• Growth rate will mirror various combinations of
cash flow patterns that reflect ebb and flow of
strategic and competitive factors
– Net operating income margin (m) after
deducting operating costs from revenues
including:
• Cost of goods sold
• Selling, general, and administrative expenses
• Depreciation expenses
– Actual tax rate (T)
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 15
– Investment (It)
• Investment as a ratio of revenues
• Defined as the change in total capital over the
previous period
• Change in total capital
– Investment in working capital, gross or net
– Investment in fixed assets, gross or net
– Number of periods of supernormal growth (n)
• Defined by firm's competitive advantage
• Supernormal growth period will end when
competition erodes the firm's competitive
advantage
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 16
– Marginal weighted cost of capital (k)
• Cost of equity
• After-tax cost of debt
• Weighted average of the two based on target
financing proportions
– Value drivers for net operating income
margin (m) and investment (I) are expressed
as a percentage of sales — could be
obtained through a linear regression
relationship with revenues
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 17
• Sensitivity analysis
– Purpose
• Check impact of a range of alternative possibilities
• Provide framework for planning and control
– Sensitivity analysis of model variables:
• Decrease in revenues growth rate (g) lowers
valuation
• Increase in investment requirement percentage (I)
lowers valuation
• Operating profit margin (m) is a powerful value
driver — when m is increased, valuation increases
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 18
• Valuation is very sensitive to the cost of capital
(k) used in analysis — when cost of capital is
increased, valuation falls
• Sensitivity to n and T predictable in direction and
magnitude
– When period of supernormal growth is reduced,
valuation is reduced
– When tax rate is reduced, valuation is increased
– In many practical cases, second term in
valuation model represents a higher
proportion of valuation than first term —
must be careful as to assumptions about
factors affecting exit or terminal value
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 19
• Limitations of the formula approach
– Less flexibility in reflecting forecasts for
individual years
– Calculations use financial statement data
not directly shown in the formulas
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 20
Cost of Capital Measurement
• Steps involved in calculation of cost of
capital
– Calculate cost of equity capital
– Calculate cost of debt
– Formulate applicable financial structure or
financial proportions
– Apply applicable financial proportions to
cost of equity and cost of debt
– Final result is weighted cost of capital
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 21
• Cost of equity
– Capital Asset Pricing Model (CAPM)
ks = Rf + [RM - Rf] j
• Risk-free rate (Rf)
– Related to returns on U.S. government bonds
– Rates on relatively long-term bonds should be used since
discount factor is used in valuation involving long periods
• Market price of risk (RM - Rf)
– For many years, estimated to be in range of 6.5 to 7.5%
– For new economic paradigm since mid 1990s, estimated to be
in the range 4% to 5%
• Beta (j )
– Measures how returns on the firm's common stock vary with
returns on the market as a whole
– High beta stocks exhibit higher volatility than low beta stocks in
response to changes in market returns
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 22
– Dividend growth model
• Cost of equity based on the constant-growth
dividend valuation model
D1
So 
ks  g

D1
ks 
g
So
• Required return on equity is expected dividend
yield (D1/S0) plus expected growth rate of
dividends in perpetuity (g)
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 23
– Bond yield plus equity risk premium
• Cost of equity = Average yield to maturity of
bonds for the industry with same rating as the
firm's debt + historical average firm's equity risk
premium over its bond yield
• For the industry, analyze historical yield on
equity as compared with average yield to
maturity on bonds for the industry
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 24
– Estimating the cost of equity capital
• Use information generated by financial
markets
• Estimate cost of equity using multiple methods
• Consider general equity market uncertainty
• Consider estimates for other companies in
same industry
• Use judgment to arrive at an estimate
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 25
• Cost of debt
– Cost of debt calculated on an after-tax
basis because interest payments are tax
deductible
After-tax cost of debt = kb(1 - T )
– Before-tax cost of debt, kb
• Can be obtained from a weighted average of
the yields to maturity of all the firm's outstanding
publicly held bonds
• Can be obtained from published promised
yields to maturity based on bond rating category
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 26
• Weighted cost of capital
– Cost of capital, k, is weighted average of
marginal cost of equity and debt
k = kb(1-T)(B/V)+ks(S/V) where:
kb
ks
T
B
S
V
=
=
=
=
=
=
cost of debt
cost of equity
tax rate
value of debt
value of equity
total value of firm = B + S
– or
k = ku(1-TL)
where:
ku = cost of capital of an unlevered firm
L = B/V
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 27
– Methodology focuses on current market
opportunity costs, not book or historical
costs
– May use book or market values to provide
guidelines
– Use judgment to estimate target financial
proportions
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 28
• Merger premiums
– It is wrong to conclude that number of shares
paid in a stock-for-stock deal is unimportant
just because it is a paper-for-paper deal
– Premium paid decides the percentage of
combined ownership each party to the
merger will control
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 29
– Higher premium paid:
• Greater the percentage ownership of the new
firm by the shareholders of the acquired firm
• Greater the value per share dilution for acquirer
shareholders
• Greater the EPS dilution for acquirer
shareholders
– Presence of merger economies from
synergies, cost savings, etc. can recover
acquirer premiums paid, could even make
mergers accretive
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 30
Summary
• All valuation methods have strengths and
weaknesses
• Employ multiple methods of valuation in
takeover analysis
• Valuation should be guided by a business
economics outlook for the firms
• Ultimately judgments are required for
valuations
©2001 Prentice Hall
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 31