VALUATION OF FIRMS IN MERGERS AND ACQUISITIONS
OKAN BAYRAK
DefinitionsA merger is a combination of two or more corporations in which only one corporation survives and the merged corporations go out of business. Statutory merger is a merger where the acquiring company assumes the assets and the liabilities of the merged companies A subsidiary merger is a merger of two companies where the target company becomes a subsidiary or part of a subsidiary of the parent company
Types of Mergers Horizontal Mergers
- between competing companiesVertical Mergers
- Between buyer-seller relation-ship companiesConglomerate Mergers
- Neither competitors nor buyer-seller relationship
History of Mergers and Acquisitions Activity in United States The First Wave 1897-1904
After 1883 depressionHorizontal mergersCreate monopoliesThe Second Wave 1916-1929
OligopoliesThe Clayton Act of 1914The Third Wave 1965-1969
Conglomerate MergersBooming EconomyThe Fourth Wave 1981-1989
Hostile TakeoversMega-mergersMergers of 1990s
Strategic mega-mergers
Motives and Determinants of Mergers Synergy Effect
Operating SynergyFinancial SynergyDiversification Economic Motives
Horizontal Integration Vertical Integration Tax Motives
NAV= Vab (Va+Vb) P E
WhereVab = combined value of the 2 firms
Vb= market value of the shares of firm B.
Va= As measure of its own value
P = premium paid for B
E= expenses of the operation
FIRM VALUATION IN MERGERS AND ACQUISITIONS Equity Valuation Models
Balance Sheet Valuation Models Book Value: the net worth of a company as shown on the balance sheet.Liquidation Value: the value that would be derived if the firms assets were liquidated. Replacement Cost: the replacement cost of its assets less its liabilities.
FIRM VALUATION IN MERGERS AND ACQUISITIONS-2Dividend Discount Models
Where Vo= value of the firm
Di= dividend in year I
k= discount rate
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FIRM VALUATION IN MERGERS AND ACQUISITIONS-3The Constant Growth DDM
And this equation can be simplified to:
where g = growth rate of dividends.
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FIRM VALUATION IN MERGERS AND ACQUISITIONS-4Price-Earnings Ratio
where PVGO = Present Value of Growth Opportunity
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Implying P/E ratio
where ROE = Return On Equity
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FIRM VALUATION IN MERGERS AND ACQUISITIONS-5Cash Flow Valuation Models
The Entity DCF Model : The entity DCF model values the value of a company as the value of a companys operations less the value of debt and other investor claims, such as preferred stock, that are superior to common equity . Value of Operations: The value of operations equals the discounted value of expected future free cash flow.
. Value of Debt
. Value of Equity
FIRM VALUATION IN MERGERS AND ACQUISITIONS-6What Drives Cash Flow and Value?
- Fundamentally to increase its value a company must do one or more of the following:. Increase the level of profits it earns on its existing capital in place (earn a higher return on invested capital).. Increase the return on new capital investment.. Increase its growth rate but only as long as the return on new capital exceeds WACC.. Reduce its cost of capital.
FIRM VALUATION IN MERGERS AND ACQUISITIONS-7The Economic Profit Model: The value of a company equals the amount of capital invested plus a premium equal to the present value of the value created each year going forward.
where ROIC = Return on Invested Capital
WACC = Weighted Average Cost of Capital
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where NOPLAT = Net Operating Profit Less Adjusted Taxes
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STEPS IN VALUATIONAnalyzing Historical Performance
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FCF=Gross Cash Flow Gross Investments
Economic Profit=NOPLAT (Invested Capital x WACC)
STEPS IN VALUATION-2Forecast Performance
Evaluate the companys strategic position, companys competitive advantages and disadvantages in the industry. This will help to understand the growth potential and ability to earn returns over WACC.Develop performance scenarios for the company and the industry and critical events that are likely to impact the performance.Forecast income statement and balance sheet line items based on the scenarios.Check the forecast for reasonableness.
STEPS IN VALUATION-3Estimating The Cost Of Capital
Develop Target Market Value WeightsEstimate The Cost of Non-equity Financing Estimate The Cost Of Equity Financing
where
kb= the pretax market expected yield to maturity on non-callable, non convertible debt
Tc= the marginal taxe rate for the entity being valued
B= the market value of interest-bearing debt
kp= the after-tax cost of capital for preferred stock
P= market value of the preferred stock
ks= the market determined opportunity cost of equity capital
S= the market value of equity
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STEPS IN VALUATION-4Estimating The Cost Of Equity Financing
CAPM
. Determining the Risk-free Rate (10-year bond rate) . Determining The Market Risk premium 5 to 6 percent rate is used for the US companies . Estimating The Beta
whererf
= the risk-free rate of return
E(rm)
= the expected rate of return on the overall market portfolio
E(rm)- rf = market risk premium
= the systematic risk of equity
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STEPS IN VALUATION-5The Arbitrage Pricing Model (APM)
whereE(Fk)= the expected rate of return on a portfolio that mimics the kth factor and is
independent of all others.
Beta k= the sentivity of the stock return to the kth factor.
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STEPS IN VALUATION-6Estimating The Continuing Value
Selecting an Appropriate Technique. Long explicit forecast approach . Growing free cash flow perpetuity formula. Economic profit technique
STEPS IN VALUATION-7Calculating and Interpreting Results
Calculating And Testing The ResultsInterpreting The Results Within The Decision Context
HP-COMPAQ MERGER CASE
The HP/Compaq merger. By The Numbers:
HIGH-END
High-end Unix Servers: Worldwide (2000)
FactoryRevenues ($m)
Market Share
Hewlett-Packard
512
11.4%
Compaq
134
3.0%
Closest Rival: Sun Microsystems with factory revenues of $2.1 billion and a 47.1% market share
High-end Unix servers: US (2000)
FactoryRevenues ($m)
Market Share
Hewlett-Packard
124
6.1%
Compaq
66
3.3%
Closest Rival: Sun Microsystems with factory revenues of $1.2 billion and a 60.1% market share
MID-RANGE
Mid-range Unix servers: Worldwide (2000)
FactoryRevenues ($m)
Market Share
Hewlett-Packard
3,673
30.3%
Compaq
488
4.0%
Closest Rival: Sun Microsystems with $2.8 billion in factory revenue and a 23.5% market share
Mid-range Unix servers: US (2000)
Factory Revenues ($m)
Market Share
Hewlett-Packard
1552
28.2%
Compaq
296
5.4%
Market Leader: Sun Microsystems with revenues of $1.7 billion and a 30.5% market share)
PERSONAL COMPUTERS
PC Shipments: Worldwide (in thousands of units)
Hewlett-Packard
Compaq
Units (q2/01)
2,065
3,590
Share (q2/01)
6.9%
12.1%
Units (q2/00)
2,260
4.011
Share(q2/00)
7.4%
13.2%
Growth
-8.6%
-10.5%
PC Shipments: US(in thousands of units)
Hewlett-Packard
Compaq
Units (q2/01)
991
1,332
Share (q2/01)
9.4%
12.7%
Units (q2/00)
1,221
2,293
Share(q2/00)
10.7%
20.1%
Growth
-18.8%
--21.3%
Market leader: Dell Computer Corp. with a 24% market share and a 9.8% growth in the same period.
LAPTOPS/NOTEBOOKS
SMART HANDHELDS
Worldwide shipments of portable computers (thousands of units)
Hewlett-Packard
Compaq
Units(q4/00)
318
817
Share(q4/00)
4.5%
11.6%
Units(q4/99)
139
739
Share(q4/99)
2.4%
13.%
Growth
129.2%
10.4%
Market leader: IBM with 932,000 units and a 13.3% market share
Shipments(in 000s)
Share 2000
Rank
Hewlett-Packard
254
3.8%
4
Compaq
129
1.9%
9
Market Leader: Palm with a 52.9% market share and 3.53 million units.
Source: IDC
HP-COMPAQ MERGER CASE-2Arguments About The Merger
Supporters. HP-COMPAQ will become the leader in most of the sub-sectors . Ability to offer better solutions to customers demands . New strategic position will make it possible to increase R&D efforts and customer research . Decrease in costs and increase in profitability. Financial strength to provide chances to invest in new profitable areas
HP-COMPAQ MERGER CASE-3Arguments About The Merger
- Opponents. Acquiring market share will not mean the leadership . No new significant technology capabilities added to HP . Large stocks will increase the riskiness of the company (Credit rating of the HP is lowered after the merger announcement) . Diminishing economies of scale sector which both companies have already a great scale.
HP-COMPAQ MERGER CASE-4Valuation Process
Relative Historical Stock Price Performance
Historical Exchange Ratios
Period ending August 31, 2001
Average Exchange Ratio
Implied Premium (%)
August 31 2001
0.532
18.9
10-Day Average
0.544
16.3
20-Day Average
0.568
11.3
30 Day Average
0.573
10.3
3 Months Average
0.557
13.7
6 Months Average
0.584
8.2
9 Months Average
0.591
7.1
12 Months Average
0.596
6.1
HP-COMPAQ MERGER CASE-5Comparable Public Market Valuation Analysis
Firm Values As a Multiple of Revenue EBITDA and LTM EBIT
Firm Values as a Multiple of
Companies
LTM Revenue
LTM EBITDA
LTM EBIT
Compaq
0.5 X
5.7 X
9.8 X
HP
1.0 X
12.4 X
19.8 X
Selected Group
0.2-2.1 X
5.3-18.2 X
8.9-19.9 X
Closing Stock Prices As a Multiple of EPS
Closing Stock Price as a Multiple of
Companies
2001 EPS
2002 EPS
2003 EPS
Compaq
34.3 X
18.4 X
14.0 X
HP
35.7 X
19.2 X
12.5 X
Selected Group
18.5-57.3 X
10.7-27.1 X
9.3-19.5 X
HP-COMPAQ MERGER CASE-6Similar Transactions Premium Analysis Salomon Smith Barney's analysis resulted in a range of premiums of:
- (8)% to 46% over exchange ratios implied by average prices for the 10 trading days prior to announcement, with a median premium of 23%.- (7)% to 58% over exchange ratios implied by average prices for the 20 trading days prior to announcement, with a median premium of 23%. - (12)% to (29) over exchange ratios implied by average prices for the 1 trading days prior to announcement with a median premium of 15%.
Based on its analysis, Salomon Smith Barney determined a range of implied exchange ratios of 0.585x to 0.680x by applying the range of premiums for other transactions to the closing prices of Compaq and HP on August 31, 2001 and the average historical exchange ratio for Compaq and HP for the 10-day period ending on August 31, 2001, as appropriate.
HP-COMPAQ MERGER CASE-7Contribution Analysis
Percentage Contribution Analysis
Period
Percentage Contribution
Compaq
HP
Revenues
LTM
46.0
54.0
2001 Estimated
44.0
56.0
2002 Estimated
44.0
56.0
2003 Estimated
44.0
56.0
LTM
45.7
54.3
2001 Estimated
38.1
61.9
2002 Estimated
36.9
63.1
2003 Estimated
32.7
67.3
Net Income
2001 Estimated
32.3
67.7
Next Four Fiscal Q
31.6
68.4
2002 Estimated
32.7
67.3
2003 Estimated
29.2
70.8
At Market
Equity Value
31.7
68.3
HP-COMPAQ MERGER CASE-8Pro Forma Earnings Per Share Impact to Compaq
Accretion/Dilution Analysis
Accretion/Dilution
EPS
2002
EPS
2003
Compaq stand-alone
0.67
0.88
HP stand-alone
1.21
1.86
Combined entity pro-forma, excluding proj. synergies
0.74
1.09
Combined entity pro-forma, including proj. synergies
1.05
1.51
Accretion/(Dilution) to Compaq, excluding proj. synergies
11%
24%
Accretion/(Dilution) to Compaq, including proj. synergies
57%
71%