Valuation Article

Merger and Acquisition ValuationAuthor(s): Samuel C. Weaver, Robert S. Harris, Daniel W. Bielinski, Kenneth F. MacKenzieSource: Financial Management, Vol. 20, No. 2 (Summer, 1991), pp. 85-96Published by: Blackwell Publishing on behalf of the Financial Management Association InternationalStable URL: http://www.jstor.org/stable/3665732 .Accessed: 20/04/2011 14:01

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Panel Discussion

Merger and Acquisition Valuation

Samuel C. Weaver, Robert S. Harris, Daniel W. Bielinski, and Kenneth F. MacKenzie

Moderator: Samuel C. Weaver, Hershey Foods Corporation. Panelists: Robert S. Harris, University of Virginia; Daniel W. Bielinski, ArthurAndersen & Company; and Kenneth F. MacKenzie, Institute of Business Appraisers.

N Merger and acquisition valuation is an important topic that receives limited attention in literature. The purpose of this session is to examine and discuss critical "real world" issues, such as screening targets, valuation models, discount rates, etc.

Samuel C. Weaver: This is a merger and acquisition valuation panel with four people of unique back- grounds. The order of presentation will be Robert S. Harris, University of Virginia; Daniel W. Bielinski, Ar- thur Andersen and Company; then I'll give my presen- tation, followed by Kenneth F. MacKenzie, Institute of Business Appraisers. Bob will bring a general academics viewpoint to the session. Dan, who has published a number of articles on mergers and acquisitions, will bring a consultant's viewpoint to the panel. I'll then present a general standard industrial viewpoint. Follow- ing me will be Ken MacKenzie, who will bring some alternative models, backgrounds, and unique views on the valuation process. After that, we'll entertain ques- tions and answers. Bob, I'll turn it over to you.

Robert S. Harris: Since Sam has let me go first, I want to give an overview of some key considerations in valuing a company. First, I'll examine the process of identifying, selecting and purchasing companies. This bigger context is important to appreciate the full benefits (and limitations) of placing a value on a com- pany. Second, I'll discuss four key issues that add layers of complexity to the use of standard valuation models in a takeover setting: uniqueness (or lack thereof) of syner- gies and competition in bidding, means of payment (e.g., cash versus stock) used in a transaction, wealth transfers among different claimants (e.g., bondholders and shareholders), and treatment of currency issues in cross-border transactions. Finally, I'll discuss some specific approaches to valuation.

Anyone who has studied or participated in an ac- quisition knows that the process is complicated and involves numerous players (from investment bankers to labor unions). From the buyer's perspective, the process might involve the following interrelated stages: strategy formulation, identification and screening of candidates,

85

86 FINANCIAL MANAGEMENT/SUMMER 1991

valuation of targets, negotiation, purchase, and im- plementation. Many key decisions are made prior to any formal valuation of a target (e.g., selection of general criteria for potential acquisitions) as is typical in a world of costly information. An instructive way to look at company valuation is in the context of negotiation and bid preparation. A valuation framework provides a dis- ciplined means for humans, who after all are the ul- timate actors, to bring together a wide array of informa- tion and understand what price can be afforded by a buyer, what price is likely to be acceptable to a seller, and importantly, what price may be affordable to another bidder. Furthermore, the valuation process is a dynamic one that allows understanding the effects of changes in key assumptions about factors such as market growth or cost structure. In a negotiation process where new information becomes available, the valuation framework is critical to providing a timely response and in limiting the occasional euphoria of a negotiating ses- sion. The valuation process also provides insight into the management challenges after takeover.

In this context, what values actually do get paid for companies? Exhibit 1 shows premiums (percent market price prior to offer) paid for U.S. targets as recorded by W. T. Grimm. While the premium averages about 40% over the 20-year period, the premium clearly varies over time; moreover, premiums differ among subsets of firms (by industry, by means of payment, etc.). The revelation of the market thus shows that takeover valuation is a very complicated business. No simple markup over current market price works. In fact, a market price is typically not even available. In 1989, Grimm recorded over 2,000 acquisitions of U.S. firms, only 14% of which were publicly traded firms. Having a current market price as a starting point is the exception, not the rule, in takeovers.

Any valuation should consider not only what the target may be worth to the buyer, but what the target's next best alternative is likely to be. For instance, suppose that when valued as a stand-alone, a target is worth $10.00, whereas, due to substantial synergies, the target is worth $15.00 as part of the buying firm. A key element for negotiations is the value of the target to another bidder. If all the synergies (the $5.00 increment in value) are unique to one buyer, the buyer may well be able to purchase for $10.01. On the other hand, if the synergies (e.g., a tax benefit) are equally available to many poten- tial bidders, the buyer likely must raise the bid close to $15.00 to buy the target. As a result, a full valuation must take into account the uniqueness of synergies and the

characteristics of other buyers, rather than be con- ducted solely on information about the target and bid- der.

In a world with taxes and information asymmetries, the form of payment (not just the nominal market value) can play a significant role. For instance, target shareholders may prefer shares (versus cash) to mini- mize personal tax liabilities since realization of capital gains can be deferred in equity offers. On the other hand, a share offering may itself raise problems if target owners have doubts about the future of the buyer. Any analyst should consider these possible effects in looking for a value which can be paid for the target. Value can depend on the form of payment.

Most valuation approaches assume that the residual owners, the shareholders, benefit or lose from changes in total corporate value. As a number of highly levered transactions have shown, however, the link between the value of the entire firm and the distribution of that value is more complex. This complexity involves wealth trans- fers, which an analyst should assess, since wealth trans- fers (as opposed to wealth creation) can provide impor- tant incentives for or against an acquisition.

To illustrate, consider a firm whose value (VF) is the sum of the values of debt (VD) and equity (VE). To be

specific, assume that prior to a takeover the target firm's value is as follows:

VF = VD + VE = $4.00 + $6.00 = $10.00.

Now suppose a buyer employs substantial borrowing (an additional $5.00 of debt over and above the target's existing debt) to buy the equity of the target. Assume that after the takeover, the value of the target firm remains at $10.00 (no net value creation) but is dis- tributed as follows:

VF = VD + VE = $8.00 + $2.00 = $10.00.

Notice that I have assumed that the value of debt goes from $4.00 to $8.00, even though an additional $5.00 is borrowed. How can $4.00 + $5.00 = $8.00? The answer is that existing debt owners (with inadequate covenants) suffer a value loss as their debt becomes more risky and is downgraded. This wealth loss of $1.00 is a direct transfer to the buyer. The buyer has used $5.00 of bor- rowing plus $1.00 of his own capital to purchase the $6.00 of equity in the target. At the end of the transac- tion, the buyer has equity value of $2.00, having had to

WEAVER, HARRIS, BIELINSKI & MACKENZIE/M&A VALUATION 87

Exhibit 1. U.S. Takeover Premium, 1970-1989

60

50

40

% over market 30

20

10

0 I I I I I I I I I I I I I I I I I I

70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89

year

Source: W. T. Grimm

invest only $1.00 of his own money. The difference is the wealth transfer from existing debt owners.

Wealth transfers can involve many different types of claimants (debt owners, employees, etc.) and can be extremely important in understanding the effects of a takeover on value. The transfers also raise ethical con- siderations since wealth redistributions often involve breaking implicit contracts with important sets of stakeholders. The important message for valuation is to examine possible wealth transfers.

Increasingly, takeovers are cross-border transactions involving operations in different countries. Analysis thus involves assessment of different economies and cul- tures. A specific challenge for valuation technique is the choice of currency in which to value the target firm. Should the analysis be in the home currency of the target firm and be tied to financial market conditions in that country? Or should the focus be on the buyer's currency and country? I'll return to this issue briefly in discussing specific valuation models.

The underlying philosophy of valuation models is straightforward. Valuation models attempt to find claims that are traded in financial markets which are reasonable substitutes for the claims offered by a target company. Market pricing substitutes can then be used

to inform valuation of the target. Valuation approaches differ largely in how substitutes are defined (be it dollars of earnings, cash flows with particular risk profiles, or accounting or replacement values of specific physical assets). I'll discuss two basic approaches: the use of multiples and discounted cash flow methods.

Whether based on publicly traded companies or recently completed takeovers, the use of "multiples" to value companies is common. Value is simply the product of a base number and the appropriate multiple. The multiple may be based on earnings, book value, cash flow or some other item. No matter how multiples are selected and applied, certain difficulties crop up. It is often difficult to find comparable companies. Account- ing cosmetics can lead to notoriously difficult problems. Especially when using earnings or cash-flow-based mul- tiples, it may be difficult, if not impossible, to capture multiyear dimensions (of life cycle or recession) in a simple calculation of multiplying one multiplier times one base number to get a value. In its worst application, the use of multiples falls into the trap of being a back- ward-looking exercise instead of the forward-looking analysis critical to any valuation. As a result, I focus on discounted cash flow analysis (DCF).

88 FINANCIAL MANAGEMENT/SUMMER 1991

Exhibit 2. Two Discounted Cash Flow Models for Takeover Valuation

I. Free cash flows, weighted average "cost" of capital FCF TVF

VF== + N t=1 (1 + Kw) (1 + Kw)N

where

FCF = Free cash flow prior to debt service Kw = Weighted average cost of capital

TVF = Terminal value of entire firm N = Planning horizon in years VF = Value of firm

II. Equity residual cash flows, "cost" of equity N ECF TVE VEZ= + N+

t=1 (1 +Ke) (1 + e)N where

ECF = Equity cash flow, after debt service TVE = Terminal value of equity

Ke = Cost of equity capital VE = Value of equity = VF - VD

The two most prevalent forms of DCF analysis ap- plied to company valuation are shown in Exhibit 2. In both cases, a finite horizon is chosen with a terminal value estimate proxying for value at the end of the planning horizon. A great deal has been written on both approaches. Here, I offer only a few comments. The free (operating) cash flow approach focuses on incremental cash flows prior to debt service and estimates the value of the entire firm VF. As a result, the value of equity (VE) is determined by subtracting the value of debt (VD) from total firm value: VE = VF - VD. The appropriate dis- count rate is a weighted cost of capital (Kw) appropriate for the business risk and financial structure of the cash flows offered by the target. The target's cost of capital (not the buyer's) is typically a useful starting point for estimating Kw, but the analyst faces challenges in that the prospective cash flows may incorporate operating synergies (perhaps different in prospective risk than the target's existing operations). Furthermore, proposed

changes in capital structure can affect Kw. The logic of the free cash flow approach is to handle financing issues in the discount rate and focus on the value of the entire firm. Given possible wealth transfers, however, one must be specially careful in valuing the debt being subtracted from VF if a reasonable estimate of equity value is to be obtained. A market value of debt must be subtracted.

A second DCF approach focuses directly on the residual cash flows to equity. Such an approach there- fore looks at equity cash flows after debt service and is particularly suitable to situations where capital struc- ture is intimately linked to the proposed transaction (such as an LBO). Discounting these equity residual cash flows by a cost of equity appropriate for the busi- ness and financial risk of the residual flows gives a direct estimate of the value of equity. A particularly nettlesome challenge is appropriately adjusting the cost of equity for risk as more debt is used.

Under ideal conditions and consistent assumptions, the free cash flow and equity residual approaches will yield the same value of equity, but in practice, they both pose substantial and slightly different challenges.

Key issues for both are: (i) the estimation of terminal values, (ii) the nature of incremental flows, (iii) the valuation of future options, and (iv) the choice of cur- rency to be used.

(i) Terminal values play a key role in the overall valuation, especially in highly levered transactions where cash flows (to equity) may be low in initial years. An analyst should be careful to use a variety of estimates and check these estimates against an overall view of the business and industry. Also, if the terminal value is of substantially different risk than intermediate term cash flows, it may be discounted at a different rate.

(ii) Valuation models call for looking at incremental cash flows derived from the takeover decision. The analyst must be careful not to attribute to the target value that can be derived by the buyer pursuing de novo investment. The acquisition is not the only course of action possible. As well, the analyst must be especially careful to curb optimism about future synergies. Getting people involved who actually must implement these synergies (e.g., people from marketing or production) may provide a reasonable check.

(iii) A difficulty with using DCF methods is valuation of management's ability to make future decisions. Often a strategic acquisition is positioned to give the buyer the option to make a future decision. Such flexibility is not easily incorporated in DCF models. Option pricing models have the potential for valuing such oppor-

WEAVER, HARRIS, BIELINSKI & MACKENZIE/M&A VALUATION 89

tunities, though application to real investments is dif- ficult.

(iv) In a cross-border context, one can state cash flows in a foreign currency and discount such flows at a cost of capital based on foreign capital market condi- tions. The resultant value can then be translated back to a buyer's home currency at spot exchange rates. Alter- natively, cash flows can be converted to home currency at projected future exchange rates and evaluated with a home currency discount rate. With strong assumptions about capital and exchange market equilibrium, the two procedures yield the same result. In practice, however, results from the two approaches can differ. Administra- tively, a firm may choose one or the other approach, though use of both provides the most complete insight into value creation. Whatever method is used, the buyer must be especially careful not to confuse estimated value creation based on a guess about exchange rates with value derived from success in real investment decisions. Cross-border acquisitions are costly ways to speculate in exchange markets.

Returning to the view of valuation as part of a larger takeover selection and negotiation process, a key use of valuation models is in organizing, developing and testing the effects of changes in key assumptions. In effect, valuation models discipline managers to confront a whole set of issues about the future of a company. By use of sensitivity analysis, the models can show how impor- tant variations in assumptions can be. The magnitude of the value change provides insight into what additional information should be gathered and analyzed. Perhaps the key for a particular target's value is cost control. If so, the buyer would do well to understand the nature of costs and think through the post-takeover steps neces- sary to effect such control. In sum, the learning in the process of doing a valuation can be an important asset in both buying and managing a company. The framework afforded by finance models allows integra- tion of the whole array of relevant information. In the end, however, the quality of judgments used in those models is the key to successful valuations and acquisi- tions. I'll now turn the panel over to Dan.

Daniel W. Bielinski: In recent years, Arthur Ander- sen has evolved into a worldwide business consulting organization. We've invested significant resources to identify client needs and to hire specialists with the expertise to meet those needs. For example, Arthur Andersen has hired a number of persons such as myself, with a background in finance and investments rather

than accounting, to counsel clients on the value of private companies that these clients are looking to buy or sell.

What I want to do today is talk about two aspects of our services in this area. First of all, I'd like to discuss the role of the merger and acquisition valuation consult- ant, whether working for Arthur Andersen or another firm. Second, I want to talk about the discounted cash flow analysis that Bob touched on briefly. DCF analysis is, by far, our most widely used tool for valuing private companies.

The role of the M&A valuation consultant is outlined in Exhibit 3. Clients who use a valuation consultant can be corporations, investor groups, or individual inves- tors. They can be looking to buy or sell a division, a subsidiary, or a stand-alone firm.

As a valuation consultant, I serve three functions: negotiation support, interfacing with deal structuring and financing, and negotiation leverage.

In offering negotiation support, it's my job to make sure my client understands the value of the subject private company before sitting down at the negotiating table. I look at value from the perspective of both a general buyer and the specific buyer or seller that my client is going to be sitting across the table from. I will look at synergies and how they might be split between buyer and seller. If I'm counseling someone on the buy side, sometimes I'm asked to come up with what might be called defensive pricing. That is, the buyer wants to pay a price that minimizes risk - buying on his terms or not at all. On the other hand, if I'm counseling someone on the sell side, the seller might want to know the highest possible selling price that can be justified, based on economics - known as "pricing on the bubble".

Let me give an example of what can happen if a client doesn't receive this negotiation support. We had a client who, unfortunately, did not come to us ahead of time. Our client was a manufacturer who had just purchased a distributor that, at the time of acquisition, was buying several product lines from a competing manufacturer. Our client reasoned, correctly, that after the acquisition these product lines would be purchased from our client by the distributor, increasing our client's manufacturing volume, profits, and so on. Unfortunately, what they did was take all the incremental manufacturing profit and include it in their discounted cash flow when formulat- ing their initial bid. So, all of a sudden, a $30 million distributor that you might have paid $34 to $35 million for because of synergies, was purchased at an initial bid of $40 million. I might add that this is not an unusual

90 FINANCIAL MANAGEMENT/SUMMER 1991

Exhibit 3. The Role of the M&A Valuation Consultant

Clients Valuation Consultant PurchaselSale of:

* Corporations I. Negotiation Support * Divisions

* Investor Groups II. Interface with Deal " * Subsidiaries Structuring/Financing

* Individual Investors * Private Firms Ill. Negotiation Leverage

event. By the way, I am changing the numbers on all these examples for confidentiality reasons, but the point is valid. It's extremely important for people that are looking to buy or sell a business to understand these issues ahead of time.

The second duty of the valuation consultant is inter- facing with the deal structuring and financing side. This is less of an issue in a straight corporate purchase than when the financing structure is a big part of an acquisi- tion. Here, you often run into two problems. On the one hand, you have those people that try to combine the financing decision with the valuation. They either take all the financing cash flows and include them in the discounted cash flow or they attempt to build a moving capital structure into the discount rate. Mixing invest- ment and financing decisions can result in a good financ- ing package, making an overpriced business look good, or vice-versa. You generally want to separate these two decisions. On the other hand, others attempt to look at the valuation question in a vacuum and ignore the bigger context within which a deal is taking place. It is incum- bent upon the valuation specialist to interface with those people who are doing the deal structuring or financing to make sure that the client's best interests are served. For example, what we often do at Arthur Andersen, after coming up with a range of values for a private company, is sit down with the people who do the struc- turing and financing and help them match up the cash flows, see if the timing of the cash flows matches the financing package that's being put together, see if the debt can be paid off in a reasonable amount of time, and

look at the tax consequences, etc. In the last year, we've had two deals that looked good from a valuation perspective, until our tax people analyzed them and found out that if the deals were done, within the first two years, there would be a very large alternative minimum tax problem in each case. It was a big enough problem that it killed each deal. The point I'm trying to make is that in bringing to the table the knowledge of how to value a company, the valuation specialist must also be cognizant of the bigger picture and serve the client's interest.

The third role of the valuation consultant is negotia- tion leverage. I'll illustrate this with another example. This summer, I had a client come to me who wanted to sell a subsidiary to the management of that subsidiary. I valued it and gave them a range of $4.5 to $5.5 million. When the client met with management, management offered them $4 million for the company. Our client said, "What do you mean, $4 million? Arthur Andersen said I shouldn't sell for less than $5 million." The subsidiary sold for $4.9 million. The client came back to us and said they felt Arthur Andersen was an integral part of this negotiation process, and helped them get more money than they otherwise would have. The point here is, they were able to both use us for leverage and to make an informed decision about an acceptable selling price.

That is what we do; the next question is "how?" There are a variety of techniques available for use by

the valuation consultant. One of these is discounted cash flow analysis. In valuing private firms, it is, by far, our most frequently used tool. There is a thought process

WEAVER, HARRIS, BIELINSKI & MACKENZIE/M&A VALUATION 91

Exhibit 4. DCF Business Valuation - Step One

Valuation Model

Projection Residual Value

(Range of (Range of

Assumptions)Multiples)

Discount Rate (Range)

Indicated Value

Valuation Crosschecks

Exhibit 5. DCF Business Valuation - Step Two

Valuation Model

Valuation Crosschecks

Implied Going-in Multiples

Implied Going-In

Payback ,

1 Vs. Periods .Going-Out PMultiples

the valuation analyst goes through in utilizing a dis- counted cash flow model to determine a range of value. This thought process could be viewed as having two steps that are iterative in nature.

The first step can be seen in Exhibit 4. This is a schematic drawing of a valuation model, with a projec- tion based on a range of assumptions for margins, growth, capital expenditures, etc.; a discount rate range derived from any number of techniques; and a residual value based on a range of going-out multiples. The lines indicate that each of the variables, while developed through independent analysis, is also related to the other variables. The three variables are combined in a way that is consistent with both the independent analyses and their interrelationships, resulting in an initial value in- dication.

Step two, shown in Exhibit 5, tests the reasonableness of this value indication. Three valuation cross-checks are utilized: implied going-in multiples, implied payback periods, and the relationship between going-in and going-out multiples. A going-in multiple relates the value indicated by the discounted cash flow model to a current earnings stream. Implied payback periods are one of the most pervasive guidelines used today; most investors generally want a five- to seven-year payback on their money. This is a guideline, not an absolute rule, but

investors are at risk and want their money out in a reasonable period of time. Of course, this guideline will vary with the nature of the subject company. A going-out multiple is the multiple implied by the assumed residual value. What to watch out for here is pricing the company by assuming a going-out multiple that is higher than the going-in multiple; for example, "I can pay 15x earnings today because I can sell in five years for 20x earnings." This will generally result in overpricing. The lines on Exhibit 5 indicate that the three cross-checks are re- lated. For example, if I have a decent payback, I can afford to pay a higher multiple.

Typically what happens when you look at the output of your valuation model the first time through is that one or more of these cross-checks don't make sense. This is the point at which the process becomes iterative, as shown in Exhibit 6. One must vary the three valuation model variables within their ranges, perhaps reevaluate the derivation of these ranges, and often rethink as- sumptions regarding reasonable values for each cross- check variable. This process continues until all of the "six boxes" (see Exhibit 6), each of the relationships within the valuation model and the valuation cross- checks, and the connection between the model and the cross-checks all make sense at the same time. When you get to this point, you do some additional sensitivity

92 FINANCIAL MANAGEMENT/SUMMER 1991

Exhibit 6. DCF Business Valuation - An Iterative Process

Valuation Model

Projection Residual Value

(Range of(Rangeof Assumptions)Gon-u

Discount Rate (Range)

Indicated Value

Valuation Crosschecks

Implied Going-In Multiples

Implied Going-in

Payback -.4 Vs.

Payback Going-Out Multiples

analysis to come up with what a reasonable range of value might be. That is the discounted cash flow ap- proach viewed as an iterative process. Thank you.

Sam Weaver: I think what Bob and Dan had to say were perfect setups for the specific comments that I'd like to make. I'm going to talk about a very generic valuation model, and why companies do acquisitions. Last year's annual report talked about some of the acquisitions that Hershey's done since 1986, and gives some of the best reasons I know of why companies do acquisitions. Hershey is going to stay focused in the food processing business, particularly in confections and pasta. Hershey has made three major confectionery acquisitions: Peter Paul/Cadbury, the Canadian confec- tionery and snack nut businesses of Nabisco Brands Ltd., and Luden's.

When we acquired Luden's, we decided to con- centrate on four main brands: 5th Avenue candy bars, Luden's throat drops, Mello Mint peppermint patties, and Queene Anne chocolate covered cherries. Luden's

used to have about 750 different products, and we streamlined to these four product lines. The driving factor in this decision was our perceived ability to ex- pand distribution of these four brands.

Our second major acquisition was the Canadian ac- quisition. The problems Bob mentioned involving foreign acquisitions were encountered by Hershey. When a company considers a foreign acquisition, the complexity grows geometrically. There are many dif- ferent issues that must be addressed. We acquired Nabisco Brands confectionery business in Canada be- cause of two factors. One was our need to achieve sufficient size in the market to have a meaningful presence. The other factor was the underutilization of chocolate production capacity in Canada. We decided we could combine plants and be much more efficient.

We purchased Peter Paul/Cadbury because we believed we could improve its operating margin by reducing manufacturing, selling, marketing, and ad- ministrative expenses. We are better positioned to achieve the desired margins.

WEAVER, HARRIS, BIELINSKI & MACKENZIE/M&A VALUATION 93

In each of these cases, Hershey was looking at private deals where they could add something.

Before discussing a specific acquisition model, I would like to discuss how our recent acquisition activity transpired. Many of our acquisition reviews are con- ducted via the sealed bid process in which a firm like Dan's might be representing a company that we would like to acquire. Dan would give our corporate director of acquisitions a call saying the company is going to sell. If we were interested, we could be one of many corpora- tions submitting a preliminary nonbinding indication of value. We would then begin the preliminary valuation process. You have to give a good preliminary value up front, or you get cut off from going to the second round. (You have to be one of the top three bidders, usually, to get into the second round and have access to more information to refine the valuation.)

The valuation focus that we use is a discounted cash flow approach. We also do the benchmarking that Dan mentioned. When you're looking at acquiring a com- pany, you're very honest right up front. As Bob men- tioned, in many cases you put your general synergies on the table and pay the company that you're acquiring for those synergies that any buyer may bring to the table (special synergies that are unique to Hershey provide interesting discussion material). So, it makes sense that the value of the acquiring firm should go up, whereas our value acquiring them really doesn't change all that much. We pay for those general synergies.

When calculating the value of an acquisition can- didate, we use a discounted cash flow model. We focus on forecasted operating cash flows. What you're really dealing with is a very large capital budgeting problem with some other ancillary aspects to it. In our business, sales growth and operating margins are the two key value drivers.

The acquisition price is calculated as the present value of forecasted operating cash flows. The acquisi- tion price is driven by: sales growth rate, operating profit margin, income tax rate, fixed capital investment, work- ing capital investment, hurdle rate, and residual value.

To find out what we can do with the prospective company, we talk to the various divisions in Hershey and ask them what they could do with these businesses. We go by our own experience to project operating perfor- mance. It may not be sophisticated, but it's not a bad place to start projecting numbers. All the various factors combine to provide a cash flow, which we forecast for 15 years.

We look at all the various aspects, perform a lot of sensitivity analyses, and then we try to highlight what's really important to senior management. In our presen- tation to management, we present all of this information as simply as possible. We try to help them focus on the strategic rationale and financial valuation. The sen- sitivity analysis, sales growth, and operating margins are the key items. Shareholder value is created by buying the target at a valuation discount and by bettering our ac- quisition plan as the company is assimilated.

When we begin negotiations, of course we start at a price below what we are willing to pay. With that, I'd like to turn it over to Ken.

Kenneth F. MacKenzie: Thank you. I found the use of a couple of terms not to make any sense to me. In one word, we talk price, another time we talk valuation. Price is what you pay and value is what you hope to get. We've got all kinds of people paying prices. If you look at all the LBO world, I'd say a lot of people aren't getting value.

What are some of the valuation issues? The environ- ment is one of our biggest time bombs right now. Many businesses right now are of uncertain value. They ac- quire companies that are sitting on environmental time bombs, where the cost to cure will exceed the value of the company. So, banks today won't give them any money until an impact study is done. The banks don't even foreclose so they won't have to take ownership.

Many people attempt to value closely held companies from the concept of the public world, but most of the time you can't find comparable public companies.

I defy you to find five closely held businesses that are profitable, that let the world know that they were up for sale. A profitable company doesn't want to let the world know they're for sale. They don't want their employees to know. They don't want their banks to know, their vendors to know, the competition to know. Who are the ones you find for sale? The ones that have to get out of business, those that can't survive. So, the principle of fair market value for closely held companies can't exist be- cause the knowledge isn't there.

We have an interesting world. Selecting comparable companies doesn't mean in the same line of business alone. What's the asset base? What's their location? What's their technology? There's about 25 items that could make the basis for comparison.

In business appraisal, you have the dilemma of trying to be independent and objective, which is what valuation is really about and being an advocate of your client's

94 FINANCIAL MANAGEMENT/SUMMER 1991

interests. Furthermore, selling price is affected by the bargaining power of the buyer versus the seller. The job of business valuation is interesting, but never easy. Thank you.

Question: What methodology do you employ when performing an international acquisition analysis?

Sam: Our current recommendation is that you would value the company in local currency, discounting it at a local cost of capital for that kind of firm. We bring that value back to a present value today in local currency and then convert at today's spot rate to determine the equivalent in U.S. dollars.

Bob: There are some trade-offs here. The alternative to Sam's view is that you have to project exchange rates in the future so that you can then convert cash flow in the local currency back to U.S. dollars and then use U.S. capital markets. I think Sam's approach is ideal, espe- cially in countries that have fairly well-developed capital markets, where it is possible to get a reasonable estimate of what capital markets are in the foreign country. Sam's approach avoids confounding the bet on exchange rates with whether the acquisition is a smart business move. Sometimes you can make a deal look good because of the exchange rate that forced the cash, not because it was good business in that country. The difficulty is a country where the capital markets are such that it's almost impossible to come up with a local cost of capital. The other problem is the portfolios problem. It may be a little harder to communicate that in the corporate world. I sort of like Sam's approach for the reasons I mentioned.

Sam: I would say my comments were specifically related to valuation. If we were looking at something sizable, lets say in Europe, we would do the valuation as I just outlined for you. Then, for things like earnings per share impact, and an internal measure called "return on net assets," we would look at impacts translated to U.S. dollars. However, the valuation would be clean like I just suggested.

Dan: Like Sam, I also value foreign firms utilizing local currency cash flows and a discount rate based on local capital markets. Some advocate an approach that converts cash flows back to dollars and increases the discount rate to account for exchange rate risk and other risk specific to a foreign investor. But as long as you have a market for the subject company in the host country, you would have potential investors not subject to the "foreign investor" risks, so a foreign buyer will not be

paid for assuming these risks. Hence, the use of local currency projections and foreign capital-market-based discount rates. My experience has been that analysts in European countries tend to build their discount rate from a government rate due to the lack of a corporate bond market comparable to that in the U.S. Further, because they don't have the extensive corporate market analysis and research that we have, European analysts tend to set risk premiums based on research done on U.S. risk premiums.

Question: In the public markets, we often find what we call "the winner's curse" - where the realized returns seem to be less than probably required in the analysis. I wonder ifyou see the same evidence in private transactions or is this some kind of anomaly we only see in public transactions?

Dan: It depends on the situation. What we've seen is that the human factor plays a big part. If you have a corporation who wants to buy a company and they're going to do some fairly good analyses on it and evaluate it objectively, chances are, they're going to do fairly well in their pricing and achieve their return objectives. When you look at a private firm like Ken was talking about, you're never quite sure what's buried there. You can try to clean up the financials as well as possible, but there's always a question and that makes buyers a little more careful about how much they're willing to bid. On the other hand, you sometimes find investor groups anxious to do a deal. They want to buy a company. You have to really try to work with them so they don't get carried away. You have to be careful, but I would say it's probably less prevalent, at least in my experience, than you would find in the public market.

Sam: I'd like to respond to that. Again, Dan has a much broader sample size than I do. But, out of the sample of three acquisitions alluded to in our annual report, two of them are clearly winners where we far exceeded the assumptions that went into a valuation effort. The third one, however, had the same strong analytical model underlying it. The model worked well. What didn't materialize too well were some of the as- sumptions. For instance, the Canadian acquisition, where we were going to consolidate twelve plants down to three or four. After working with it, we found we couldn't pick up our equipment and move it right in and resume previous levels of efficiency overnight. From my perspective, that may not have been any different than

WEAVER, HARRIS, BIELINSKI & MACKENZIE/M&A VALUATION 95

if it was a public company as opposed to a private. Again, that's a sample of only three companies.

Question: When developing a residual value, do you calculate it on an "after-tax sales proceeds" basis?

Sam: I'll give a very mechanical reaction. If you're looking at terminal value in my model in that fifteenth year, the residual value is based on the capitalization of after-tax cash flows.

Question: So what you're saying is that Hershey's tax rate and position are included in the residual value as opposed to a potential buyer's?

Sam: Good point. I would come back and offer you that, again, the premise underlying the residual value underlies the dividend growth model, so either that's a terminal value indicating what we would sell the busi- ness for or that's a terminal value representing the present value of the future cash flows in years sixteen through infinity.

Question: So you view it as representing future cash flows to Hershey, rather than an actual planned sale?

Sam: True. Our views tend to be more of "this will continue to be a company in the Hershey fold, so what is it worth on that basis," but it is at a point when we go back and look at the residual value of those occasions. We have different opinions on what would be done.

Dan: We also basically do what Sam was talking about. It's not a case of saying, "Well, I'm going to sell this company and what are my after-tax proceeds." We take the viewpoint, as Sam explained, that this number represents the present value of all the future cash flows up to that point and we bring that number back to its present value.

Question: I get the impression that, in the typical acquisition analysis, the acquiring firm will frequently visualize a repair job of some kind to be done on what they're buying, or will visualize economies of scale, or will visualize synergies, and the history seems to say that these estimates are frequently rose-colored, shall we say. Dan, I guess my question is primarily to you and it's an extension of what you all have been talking about. Could you com- ment on recurring sources of overoptimism by acquiring firms in your experience? Where do these things usually go wrong?

Dan: Buyers tend to underestimate future capital expenditures and the working capital investment re- quired in order to achieve their projected sales and margins. They find it difficult to carve as much out of operating expenses as they thought they could, and often underestimate the transition time and costs required to implement operating changes. Risk is often not ade- quately captured, for example, by using the buyer's own discount rate rather than that of the target. Those types of things. When I value a company in this context, I tend to two-step it. First, I will value the company on a stand-alone basis, and then make a conservative es- timate of synergies. This is particularly true from a buy-side perspective. I also look at what other potential buyers there are and how much of those synergies my buyer would need to pay for - what kind of split there would be of those synergies between buyer and seller.

Sam: If I could respond to maybe an ancillary ques- tion associated with that, in that offering document that you always get in the sealed bid process, there are two things that are generally included. One, if the seller realizes he is going to sell his business well enough in advance, it's funny how that final year of actual perfor- mance has been adjusted cosmetically to reflect a good performance within that final year. My second point is that we typically look at that final year of actual perfor- mance along with the five to ten years of projections that are provided for information or perspective only. We rarely look at their final year performance and base anything on that. We'll go back a few years, and bring in our own people to better assess the situation.

Question: How do you determine the optimum debt capacity and the cost of equity?

Sam: Hershey is grossly underleveraged. So, we al- ways only think about issuing debt for the size of acquisi- tions that we look at. We don't even consider issuing equity. Our cost of capital that we would use would be our current corporate weighted average cost of capital, say 12%.

Question: How do you estimate your cost of capital?

Sam: We do have some debt. About 16% of our capital structure is debt on book basis. Our after-tax cost of debt is 5.5%. Our cost of equity using CAPM is about 14.5 - 15% and we just do the mechanics to come up with 12%.

96 FINANCIAL MANAGEMENT/SUMMER 1991

Dan: In selecting an "optimal" capital structure, I'll take a look at what the company has done historically. Each company is individual, and if the company is profitable and seems to have a reasonable level of debt, (it's typically acknowledged that it's good to have some debt on the books), this becomes one important factor. I'll also look at industry norms to get a feel for what a reasonable capital structure would be. In terms of equity rates, I look at the market first and always bring my

answer back to the market to be sure it makes sense. In developing a cost of equity, I may look at CAPM but typically use a built-up approach. I'll begin with the company's marginal cost of debt, add an equity risk premium based on certain investment banker's studies, look at a small firm premium and then start evaluating specific risk areas for the subject company.

Sam: I see we're out of time. Thank you very much for coming.

JOURNAL OF FINANCIAL MANAGEMENT AND ANALYSIS INTERNATIONAL REVIEW OF FINANCE

Vol. 3 No. 2 July-December 1990

Contents Page Nos. Foreword i - iii

World Organizations Rely on JFMA as Judicious Financial Adviser iv

Journal of Financial Management and Analysis Acquires Global Recognition v - xi

Financial Management Indicators to Aid Decision Making (Statistics) xii - xxii

Miller, E.M Arbitrage Pricing Theory: A Counter-Example 1-8 Barua. S.K. & Srinivasan, G Application of Markov Chain Evaluation andMonitoring of Lease 9- 13

Swamy, M.R.K A Financial Analysis of Model Housing Scheme for Low Income 14-28 Earners in Developing Countries: A Case Study

Dadibhavi, R. V An Appraisal of Infrastructure Development Financing in the 29-35 Indian Economy: A Methodological Approach to Analyze Regional Imbalances

Nwosu, A. C A Financial Management Appraisal of Rural Underdevelopment 36 -40 in the Imo State of Nigeria

Nagaraja, G.N. & An Examination of Rural Credit Delivery System vis-a-vis 41 - 44 Venkataram. J. V Cropping Pattern by Peasant Farmers in India -- A Case Study:

Application of Linear Programming Technique Ngiam. Kee-Jin Functional Relationship between Macroeconomic Data 45-50

Announcements and Canada-U.S.A. Exchange Rate Fluctuations: Application of Efficient Markets Hypothesis

Pandey. I.M. & Bhat, R Significance of Financial Goals Pursued by 51 - 61 Companies in India: Survey Findings

Taiwo. I. 0 An Appraisal of Federal Government Expenditure Pattern in 62- 67 Nigeria (1960-1986) Employing Chi-square (•C2) Test

Om Sai Ram Centre for Financial Management Research and Training The Anatomy ofJohnson Matthey Bank (JMB) Collapse: 68- 79 Need for Strengthening Accounting Information

Financial Management Digest

Guidelines for Bankers (A) Are Balance Sheets Meaningful and Trustworthy? (B) Need for Broadbased Environment Accounting Standards (C) Notes on Joint Account (D) On Forged Cheques 'Profession' News & Announcements:

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