SIM/NYU The Job of the CFO Valuation for Mergers & Acquisitions Prof. Ian Giddy New York University What’s a Company Worth to Another Company? Required Returns Types of Models Yeo Hiap Seng Balance sheet models Dividend discount & corporate cash flow models Price/Earnings ratios Option models Estimating Growth Rates Application: How These Change with M&A Copyright ©2000 Ian H. Giddy Valuation for M&A 2 Framework for Assessing Retructuring Opportunities Current market overpricing or underpricng Current Market Value 1 Company’s DCF value 2 5 Restructuring Framework Operating improvements Total restructured value Financial structure improvements (Eg Increase D/E) 4 3 Potential value with internal improvements Copyright ©2000 Ian H. Giddy Maximum restructuring opportunity Disposal/ Acquisition opportunities Potential value with internal + external improvements Valuation for M&A 3 Equity Valuation: From the Balance Sheet Value of Assets Book Liquidation Replacement Value of Liabilities Book Market Value of Equity Copyright ©2000 Ian H. Giddy Valuation for M&A 4 Relative Valuation Do valuation ratios make sense? • Price/Earnings (P/E) ratios and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples) • Price/Book (P/BV) ratios and variants (Tobin's Q) • Price/Sales ratios It depends on how they are used -- and what’s behind them! Copyright ©2000 Ian H. Giddy Valuation for M&A 5 Discounted Cashflow Valuation: Basis for Approach t = n CF t Value = t t =1 (1+ r) where n = Life of the asset CFt = Cashflow in period t r = Discount rate reflecting the riskiness of the estimated cashflows Copyright ©2000 Ian H. Giddy Valuation for M&A 6 Valuing a Firm with DCF: An Illustration Historical financial results Adjust for nonrecurring aspects Gauge future growth Projected sales and operating profits Adjust for noncash items Projected free cash flows to the firm (FCFF) Year 1 FCFF Year 2 FCFF Year 3 FCFF Year 4 FCFF Discount to present using weighted average cost of capital (WACC) Present value of free cash flows Copyright ©2000 Ian H. Giddy + cash, securities & excess assets - Market value of debt … Terminal year FCFF Stable growth model or P/E comparable Value of shareholders equity Valuation for M&A 7 Valuation Example Fong Industries (Pte) Ltd Singapore Profit & Loss (S$'000) FYE 30 Jun Turnover 1994 1995 1996 1997 1998 1999 9,651 57,888 125,010 120,323 136,003 134,813 Directors' Fees & Rem Amortisation Depreciation Interest Expense Bad Debts W/O Fixed Assets W/O FX loss 107 0 639 227 249 269 1,041 445 368 279 1,277 615 820 280 3,812 1,002 964 39 4,494 697 85 961 35 4,673 1,078 100 543 282 Profit b/f Tax 933 1,250 3,774 6,897 4 1,990 838 Assoc Co (74) 933 Tax Profit a/f Tax Effective Tax Rate 1,990 3 930 1,990 0.32% 0.00% EBITDA ISC Copyright ©2000 Ian H. Giddy 3,745 792.51% 841.57% 108.17% (14) 1,176 3,811 6,883 96 292 929 178 742 884 2,882 6,705 24.83% 24.38% 2.59% (768) (7) (156) 7,292 1,799 37 838 11.46% EOI 27 3,009 489.27% -19.65% 6,270 625.75% 108.37% 9,597 890.26% #### 12,113 1737.88% Valuation for M&A 8 Valuation Example Fong Industries Growth1 Growth2 Tax Revenue Expenses EBIT WC b (unlevered) b (levered) Kd MVe MVd Combined Rm Rf Ke WACC Copyright ©2000 Ian H. Giddy 25% 5% 25% 134,813 91.01% 7,580 10% 1.06 1.09 5.50% 218,993 7,379 226,372 12.00% 4.00% for 3 years thereafter effective (S$'000); T0 of Revenue (S$'000) of Revenue (S$'000) (S$'000) (S$'000) PERMkt 32.66 Revenue -Expenses -Depreciation EBIT EBIT(1-t) +Depreciation -CapEx -Change in WC FCFF Firm Value Equity Value PERcomputed 147,773 140,394 20.94 T1 168,516 153,375 4,533 10,608 7,956 4,533 4,533 3,370 4,586 T2 210,645 191,719 4,533 14,394 10,795 4,533 4,533 4,213 6,582 4,586 6,582 T3 263,307 239,648 4,533 19,125 14,344 4,533 4,533 5,266 9,078 187,655 196,733 T4 276,472 251,631 4,533 20,308 15,231 4,533 4,533 1,317 13,915 $0.65 12.69% 12.41% Valuation for M&A 9 Estimating Future Cash Flows Copyright ©2000 Ian H. Giddy Dividends? Free cash flows to equity? Free cash flows to firm? Valuation for M&A 10 The Weighted Average Cost of Capital Choice Cost 1. Equity - Retained earnings - New stock issues - Warrants Cost of equity - depends upon riskiness of the stock - will be affected by level of interest rates Cost of equity = riskless rate + beta * risk premium 2. Debt - Bank borrowing - Bond issues Cost of debt - depends upon default risk of the firm - will be affected by level of interest rates - provides a tax advantage because interest is tax-deductible Cost of debt = Borrowing rate (1 - tax rate) Debt + equity = Capital Cost of capital = Weighted average of cost of equity and cost of debt; weights based upon market value. Cost of capital = kd [D/(D+E)] + ke [E/(D+E)] Copyright ©2000 Ian H. Giddy Valuation for M&A 11 Valuation: The Key Inputs A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever. t = CF t Value = t t = 1 (1+ r) Since we cannot estimate cash flows forever, we estimate cash flows for a “growth period” and then estimate a terminal value, to capture the value at the end of the period: t = N CFt Terminal Value Value = N t (1 + r) (1 + r) t =1 Copyright ©2000 Ian H. Giddy Valuation for M&A 12 Dividend Discount Models: General Model Dt Vo t t 1 (1 k ) V0 = Value of Stock Dt = Dividend k = required return Copyright ©2000 Ian H. Giddy Valuation for M&A 13 Specified Holding Period Model D D V (1 k ) (1 k ) 1 0 2 1 P D ... (1 k ) N 2 N N PN = the expected sales price for the stock at time N N = the specified number of years the stock is expected to be held Copyright ©2000 Ian H. Giddy Valuation for M&A 14 No Growth Model D Vo k Stocks that have earnings and dividends that are expected to remain constant Preferred Stock Copyright ©2000 Ian H. Giddy Valuation for M&A 15 No Growth Model: Example D Vo k Burlington Power & Light has earnings of $5 per share and pays out 100% dividend The required return that shareholders expect is 15% The earnings are not expected to grow but remain steady indefinitely What’s a BPL share worth? E1 = D1 = $5.00 k = .15 V0 = $5.00 / .15 = $33.33 Copyright ©2000 Ian H. Giddy Valuation for M&A 16 Constant Growth Model Do (1 g ) Vo kg g = constant perpetual growth rate Copyright ©2000 Ian H. Giddy Valuation for M&A 17 Constant Growth Model: Example Do (1 g ) Vo kg Motel 6 has earnings of $5 per share. It reinvests 40% and pays out 60%dividend The required return that shareholders expect is 15% The earnings are expected to grow at 8% per annum What’s an M6 share worth? E1 = $5.00 b = 40% k = 15% (1-b) = 60% D1 = $3.00 g = 8% V0 = 3.00 / (.15 - .08) = $42.86 Plowback rate Copyright ©2000 Ian H. Giddy Valuation for M&A 18 Estimating Dividend Growth Rates g ROE b g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate i.e.(1- dividend payout percentage rate) Copyright ©2000 Ian H. Giddy Valuation for M&A 19 Or Use Analysts’ Expectations? Copyright ©2000 Ian H. Giddy Valuation for M&A 20 Shifting Growth Rate Model (1 g1) DT (1 g 2 ) V o Do t T ( k g 2 )(1 k ) t 1 (1 k ) T t g1 = first growth rate g2 = second growth rate T = number of periods of growth at g1 Copyright ©2000 Ian H. Giddy Valuation for M&A 21 Shifting Growth Rate Model: Example D0 = $2.00 g1 = 20% g2 = 5% k = 15% T = 3 D1 = 2.40 D2 = 2.88 D3 = 3.46 D4 = 3.63 V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3 + D4 / (.15 - .05) ( (1.15)3 Mindspring pays dividends $2 per share. The required return that shareholders expect is 15% The dividends are expected to grow at 20% for 3 years and 5% thereafter What’s a Mindspring share worth? V0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40 Copyright ©2000 Ian H. Giddy Valuation for M&A 22 Stable Growth and Terminal Value When a firm’s cash flows grow at a “constant” rate forever, the present value of those cash flows can be written as: Value = Expected Cash Flow Next Period / (r - g) where, r = Discount rate (Cost of Equity or Cost of Capital) g = Expected growth rate This “constant” growth rate is called a stable growth rate and cannot be higher than the growth rate of the economy in which the firm operates. While companies can maintain high growth rates for extended periods, they will all approach “stable growth” at some point in time. When they do approach stable growth, the valuation formula above can be used to estimate the “terminal value” of all cash flows beyond. Copyright ©2000 Ian H. Giddy Valuation for M&A 23 Growth Patterns A key assumption in all discounted cash flow models is the period of high growth, and the pattern of growth during that period. In general, we can make one of three assumptions: there is no high growth, in which case the firm is already in stable growth there will be high growth for a period, at the end of which the growth rate will drop to the stable growth rate (2-stage) there will be high growth for a period, at the end of which the growth rate will decline gradually to a stable growth rate(3stage) The assumption of how long high growth will continue will depend upon several factors including: the size of the firm (larger firm -> shorter high growth periods) current growth rate (if high -> longer high growth period) barriers to entry and differential advantages (if high -> longer growth period) Copyright ©2000 Ian H. Giddy Valuation for M&A 24 Length of High Growth Period Assume that you are analyzing two firms, both of which are enjoying high growth. The first firm is Earthlink Network, an internet service provider, which operates in an environment with few barriers to entry and extraordinary competition. The second firm is Biogen, a bio-technology firm which is enjoying growth from two drugs to which it owns patents for the next decade. Assuming that both firms are well managed, which of the two firms would you expect to have a longer high growth period? Earthlink Network Biogen Both are well managed and should have the same high growth period Copyright ©2000 Ian H. Giddy Valuation for M&A 25 Choosing a Growth Pattern: Examples Company Disney Valuation in Nominal U.S. $ Firm Aracruz Real BR Equity: FCFE Deutsche Bank Nominal DM Equity: Dividends Copyright ©2000 Ian H. Giddy Growth Period Stable Growth 10 years 5%(long term (3-stage) nominal growth rate in the U.S. economy 5 years 5%: based upon (2-stage) expected long term real growth rate for Brazilian economy 0 years 5%: set equal to nominal growth rate in the world economy Valuation for M&A 26 The Building Blocks of Valuation Choose a Cash Flow Dividends Expected Dividends to Stockholders Cashflows to Equity Cashflows to Firm Net Income EBIT (1- tax rate) - (1- ) (Capital Exp. - Deprec’n) - (Capital Exp. - Deprec’n) - Change in Work. Capital - (1- ) Change in Work. Capital = Free Cash flow to Equity (FCFE) = Free Cash flow to Firm (FCFF) [ = Debt Ratio] & A Discount Rate Cost of Equity Cost of Capital WACC = ke ( E/ (D+E)) Basis: The riskier the investment, the greater is the cost of equity. Models: CAPM: Riskfree Rate + Beta (Risk Premium) + kd ( D/(D+E)) kd = Current Borrowing Rate (1-t) E,D: Mkt Val of Equity and Debt APM: Riskfree Rate + Betaj (Risk Premiumj): n factors & a growth pattern Stable Growth Two-Stage Growth g g Three-Stage Growth g | t Copyright ©2000 Ian H. Giddy High Growth | Stable High Growth Transition Stable Valuation for M&A 27 The Building Blocks of Valuation Choose a Cash Flow Dividends Expected Dividends to Stockholders Cashflows to Equity Cashflows to Firm Net Income EBIT (1- tax rate) - (1- ) (Capital Exp. - Deprec’n) - (Capital Exp. - Deprec’n) - Change in Work. Capital - (1- ) Change in Work. Capital = Free Cash flow to Equity (FCFE) = Free Cash flow to Firm (FCFF) [ = Debt Ratio] & A Discount Rate Spreadsheet example Cost of Equity Cost of Capital WACC = ke ( E/ (D+E)) Basis: The riskier the investment, the greater is the cost of equity. Models: CAPM: Riskfree Rate + Beta (Risk Premium) + kd ( D/(D+E)) kd = Current Borrowing Rate (1-t) E,D: Mkt Val of Equity and Debt APM: Riskfree Rate + Betaj (Risk Premiumj): n factors & a growth pattern Stable Growth Two-Stage Growth g g Three-Stage Growth g | t Copyright ©2000 Ian H. Giddy High Growth | Stable High Growth Transition Stable Valuation for M&A 28 Relative Valuation In relative valuation, the value of an asset is derived from the pricing of 'comparable' assets, standardized using a common variable such as earnings, cashflows, book value or revenues. Examples include -• Price/Earnings (P/E) ratios and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples) • Price/Book (P/BV) ratios and variants (Tobin's Q) • Price/Sales ratios Copyright ©2000 Ian H. Giddy Valuation for M&A 29 Price Earnings Ratios P/E Ratios are a function of two factors Required rates of return (k) Expected growth in dividends Uses Relative valuation Extensive use in industry Copyright ©2000 Ian H. Giddy Valuation for M&A 30 Ratios Do Have Meaning P0 DPS1 r gn Gordon Growth Model: Dividing both sides by the earnings, P0 Payout Ratio * (1 g n ) PE = EPS0 r-gn Dividing both sides by the book value of equity, P0 ROE * Payout Ratio * (1 g n ) PBV = BV 0 r-g n If the return on equity is written in terms of the retention ratio and the expected growth rate P0 ROE - gn PBV = BV 0 r-gn Dividing by the Sales per share, P0 Profit Margin * Payout Ratio * (1 g n ) PS = Sales 0 r-gn Copyright ©2000 Ian H. Giddy Valuation for M&A 31 P/E Ratio: No expected growth E1 P0 k P0 1 E1 k E1 - expected earnings for next year E1 is equal to D1 under no growth k - required rate of return Copyright ©2000 Ian H. Giddy Valuation for M&A 32 P/E Ratio with Constant Growth D1 E 1(1 b) P0 k g k (b ROE ) P0 1 b E 1 k (b ROE ) Where b = retention ratio ROE = Return on Equity Copyright ©2000 Ian H. Giddy Valuation for M&A 33 Numerical Example: No Growth E0 = $2.50 g = 0 k = 12.5% P0 = D/k = $2.50/.125 = $20.00 P/E = 1/k = 1/.125 = 8 Copyright ©2000 Ian H. Giddy Quickie Broom Co has earnings of $2.50 per share. It pays out 100%dividend The required return that shareholders expect is 12.5% (based on CAPM with Beta of 1, RF = 7%, Market risk premium 5.5%) What PE ratio should such a company have? Valuation for M&A 34 Numerical Example with Growth b = 60% ROE = 15% (1-b) = 40% E1 = $2.50 (1 + (.6)(.15)) = $2.73 D1 = $2.73 (1-.6) = $1.09 k = 12.5% g = 9% P0 = 1.09/(.125-.09) = $31.14 PE = 31.14/2.73 = 11.4 Or PE = (1 - .60) / (.125 - .6(.15)) = 11.4 Copyright ©2000 Ian H. Giddy Valuation for M&A 35 Disney: Relative Valuation Company PE King World Productions 10.4 Aztar 11.9 Viacom 12.1 All American Communications GC Companies 20.2 Circus Circus Enterprises 20.8 Polygram NV ADR 22.6 Regal Cinemas 25.8 Walt Disney 27.9 AMC Entertainment 29.5 Premier Parks 32.9 Family Golf Centers 33.1 CINAR Films 48.4 Average 27.44 Copyright ©2000 Ian H. Giddy Expected Growth 7.00% 12.00% 18.00% 15.8 15.00% 17.00% 13.00% 23.00% 18.00% 20.00% 28.00% 36.00% 25.00% 18.56% PE ratio divided by the growth rate PEG 1.49 0.99 0.67 20.00%0.79 1.35 1.22 1.74 1.12 1.55 1.48 1.18 0.92 1.94 1.20 Valuation for M&A 36 Is Disney fairly valued? Based upon the PE ratio, is Disney under, over or correctly valued? Based upon the PEG ratio, is Disney under valued? Under Valued Over Valued Correctly Valued Under Valued Over Valued Correctly Valued Will this valuation give you a higher or lower valuation than the discounted CF valuation? Higher Lower Copyright ©2000 Ian H. Giddy Valuation for M&A 37 Relative Valuation Assumptions Assume that you are reading an equity research report where a buy recommendation for Viacom is being based upon the fact that its PE ratio is lower than the average for the industry. Implicitly, what is the underlying assumption or assumptions being made by this analyst? The sector itself is, on average, fairly priced The earnings of the firms in the group are being measured consistently The firms in the group are all of equivalent risk The firms in the group are all at the same stage in the growth cycle The firms in the group are of equivalent risk and have similar cash flow patterns All of the above Copyright ©2000 Ian H. Giddy Valuation for M&A 38 Equity Valuation: Application to M&A Prof. Ian Giddy New York University How Much Should We Pay? Applying the discounted cash flow approach, we need to know: 1.The incremental cash flows to be generated from the acquisition, adjusted for debt servicing and taxes 2.The rate at which to discount the cash flows (required rate of return) 3.The deadweight costs of making the acquisition (investment banks' fees, etc) Copyright ©2000 Ian H. Giddy Valuation for M&A 40 The Gains From an Acquisition Gains from merger Synergies Top line Copyright ©2000 Ian H. Giddy Bottom line Control Financial restructuring Business Restructuring (M&A) Valuation for M&A 42 Framework for Assessing Retructuring Opportunities Current market overpricing or underpricng Current Market Value 1 Company’s DCF value 2 5 Restructuring Framework Operating improvements Total restructured value Financial structure improvements (Eg Increase D/E) 4 3 Potential value with internal improvements Copyright ©2000 Ian H. Giddy Maximum restructuring opportunity Disposal/ Acquisition opportunities Potential value with internal + external improvements Valuation for M&A 43 Equity Valuation in Practice Estimating discount rate Estimating cash flows Application to Optika Application in M&A: Schirnding-Optika Copyright ©2000 Ian H. Giddy Valuation for M&A 44 Optika Optika Growth Tax rate Initial Revenues COGS WC WACC: Equity Market Value Debt Market Value ReE/(D+E)+RdD/(D+E) Beta Treasury bond rate Debt spread Market risk premium Value: FCFF/(WACC-growth rate) Revenues -COGS -Depreciation =EBIT Equity Value: EBIT(1-Tax) Firm Value - Debt Value -Change in WC = 2278-250 = 2028 =Free Cash Flow to Firm Cost of Equity (from CAPM) Cost of Debt (after tax) WACC Firm Value Copyright ©2000 Ian H. Giddy 5% 35% 3125 89% 10% 1300 250 1 7% 1.5% 5.50% T+1 3281 2920 74 287 187 16 171 12.50% 5.53% 11.38% CAPM: 7%+1(5.50%) Debt cost (7%+1.5%)(1-.35) 2278 Valuation for M&A 45 Optika & Schirnding Schirnding-Optika Optika Growth Tax rate Initial Revenues COGS WC Equity Market Value Debt Market Value Beta Treasury bond rate Debt spread Market risk premium Revenues -COGS -Depreciation =EBIT EBIT(1-Tax) -Change in WC =Free Cash Flow to Firm Cost of Equity (from CAPM) Cost of Debt (after tax) WACC Firm Value Copyright ©2000 Ian H. Giddy 5% 35% 3125 89% 10% 1300 250 1 7% 1.5% 5.50% Schirnding 5% 35% 4400 87.50% 10% 2000 160 1 7% 1.5% 5.50% Combined 5% 35% 7525 T+1 3281 2920 74 287 187 16 171 12.50% 5.53% 11.38% T+1 4620 4043 200 378 245 22 223 12.50% 5.53% 11.98% 7901 6963 274 664 432 38 394 12.50% 5.53% 11.73% 2278 3199 5859 10% 3300 410 1 7% 1.5% 5.50% Valuation for M&A 46 Optika-Schirnding with Synergy Schirnding-Optika Optika Growth Tax rate Initial Revenues COGS WC Equity Market Value Debt Market Value Beta Treasury bond rate Debt spread Market risk premium Revenues -COGS -Depreciation =EBIT EBIT(1-Tax) -Change in WC =Free Cash Flow to Firm Cost of Equity (from CAPM) Cost of Debt (after tax) WACC Firm Value Increase Copyright ©2000 Ian H. Giddy 5% 35% 3125 89% 10% 1300 250 1 7% 1.5% 5.50% Schirnding 5% 35% 4400 87.50% 10% 2000 160 1 7% 1.5% 5.50% T+1 3281 2920 74 287 187 16 171 12.50% 5.53% 11.38% 2278 Combined 5% 35% 7525 10% 3300 410 1 7% 1.5% 5.50% Synergy 5% 35% 7525 86.00% 10% 3300 410 1 7% 1.5% 5.50% T+1 4620 4043 200 378 245 22 223 12.50% 5.53% 11.98% 7901 6963 274 664 432 38 394 12.50% 5.53% 11.73% T+1 7901 6795 274 832 541 38 503 12.50% 5.53% 11.73% 3199 5859 7479 1620 Valuation for M&A 47 Breaking Up is Hard to Do Copyright ©2000 Ian H. Giddy Valuation for M&A 50 Implementation Case Studies: Intraco Natsteel Copyright ©2000 Ian H. Giddy Valuation for M&A 51 Fish and Chips Intraco's eclectic menu of products and services includes fish and chips: It operates in telecommunications, commodities, foods (such as saltwater fish), engineering, and semiconductors (chips). Its Teledata subsidiary provides telecom services and products and project management. Intraco Trading buys and sells plastics, petrochemicals, and metals. Intraco Foods deals in seafood, dairy products, fruit, and frozen food. The engineering and projects unit has five divisions: electrical, building materials, land transport, marine and port, and environmental engineering. The semiconductor unit distributes such products as DRAMs and AMD microprocessors. The firm has shed its auto unit. NatSteel owns 22% of Intraco. http://www.intraco.com.sg Copyright ©2000 Ian H. Giddy Valuation for M&A 52 Natsteal Just as a metallurgist mixes metals to produce a strong alloy, NatSteel mixes steelmaking and a variety of other activities to make it one of Singapore's largest industrial groups. NatSteel's range of operations includes electronics, building products (cement and precast concrete), chemicals, engineering products and services, and property development. Its steel division has mini-mills in China, Malaysia, the Philippines, Singapore, and Vietnam. Its electronics division consists of two contract manufacturers. The company has an e-commerce initiative to transform its steel commodities into a value-added service business. NatSteel's operations span 15 countries in Asia, Australia, and Europe. http://www.natsteel.com.sg Copyright ©2000 Ian H. Giddy Valuation for M&A 53 The Gains From an Acquisition Gains from merger Synergies Top line Copyright ©2000 Ian H. Giddy Bottom line Control Financial restructuring Business Restructuring (M&A) Valuation for M&A 54 www.giddy.org giddy.org Ian Giddy NYU Stern School of Business Tel 212-998-0332 Fax 917-463-7629 ian.giddy@nyu.edu http://giddy.org Copyright ©2000 Ian H. Giddy Valuation for M&A 60