Merger and Acquisi/on Part 2

Corpora/on, Merger & Acquisi/on, and

Managing Subsidiaries
Target Valua/on

Robert F Bruner, Applied Mergers & Acquisi8ons,, John Wiley & Sons
Sudi Sudarsanan, Crea8ng Value from M&A , FT & Pren8ce Hall
Fundamental Finance : WileyV
Damodaran: various sources
 Bidding Strategy

• Maximum price or “walk away”

• Set within certain range
• Incremental value due to improve opera8on of
the target/synergy/profitability target asset
disposal
 The ability to appropriate
Depend on:
1. Whether the synergies are unique to the bidder &
target bilateral nego8a8on
2. Whether there are several targets for each bidder
compete down take over price
3. Whether there are several bidders for each target
target can play off the bidders
4. The offer price is subject to any regulatory determina8on
5. The rela8ve bargaining strengths the bidder and target

1-3 also reflect the behavioral impera8ves of each party to nego8ate

 Key Issue in Target Valua/on

• Totality incremental earnings & cash flows

• To be reflected in post acquisi8on
• It will not precise due to the difficulty to forecast
• Hence, expose the bidder to the valua8on risk
 Basic Valua/on Models

1. Mul8ples / Rela8ve valua8on

2. Discounted Cash Flows
 Synergies

1. Revenue enhancement:
a. Market Power: increase price due to market power (incl elimina8on of compe8tor
and capacity)
b. Sales volume: cross selling, co-produc8on, across value chain, hence increase
market share
c. Diversifica8on: product, services, technology, distribu8ons, logis8cs, talents, risk
mi8ga8on with uncorrelated cash flows
2. Cost reduc/ons: reduce duplica8on cost, economic of scale/scope, R&D, learning
curve, branding, replacement of in-effec8ve managers
3. Asset Reduc/on: reduce excess inventory, fill in vacant property , disposal of idle/
half idle assets
4. Tax reduc/on: tax loss carry forward, offset loss
5. Financial: reduce WACC, valua8on ra8o (undervalued: buy low sell high)
6. Other real op/ons: growth due to new business model to compete, new capabili8es
& resources, new product/market/resources, exit (dependence), defer, etc

7
Scenarios for Synergies
 Connec/ng Strategic Drivers to
Financial Drivers
M&A is aimed at strengthening the compe88ve advantage and it
reflected in incremental value crea8on:

• The value sources rooted in the business model

• The Biz Model leading to the advantages driving the merger
• If the strategic drivers disconnect to financial drivers, it can cause
over or under es8mate of incremental value

The disconnec8on is du e to the poor specifica8on of the business model

underpinning the merger, and poor ar8cula8on of its implica8on of: revenue,
cost, investment, risk and CoC
Connec/ng Strategic Drivers to
Financial Drivers
 Environment Changes
Competition Arena

???

???
Valua/on Models
 What is Valuation?
• Valuation is the act or process of determining the value of a
business

Major Valuation Method:

1. Discounted Cash Flow => FreeCashFlow (FCF)
2. Market Approach => Relative/Comparative Multiplies
 Major Approaches to Valua/on

1. Discounted Cash flow Valua/on

Relates the value of an asset to the present value of expected future cash flows
on that asset.

3. Market Approach : Rela/ve/Mul/ple valua/on

Es8mates the value of an asset by looking at the pricing of 'comparable' assets
rela8ve to a common variable like earnings, cashflows, book value or sales.
 Discounted Cash Flow Method

“the value of an asset is the present value of its expected future cash
flows discounted at an appropriate rate of return that
commensurate with associated risk”.

∞
E[ FCFt ]
V =∑ t
t =1 (1 + k )
 Expected Free Cash Flows

Value depends on the

future cash flows generated
by the business
∞
E[ FCFt ]
V =∑ t
t =1 (1 + k )
Timing
Risk
Business cash flows
must be forecast over
the life of the business Because business cash
or project, t flows are risky, they must
be discounted the risky
discount rate, k
Free cash flow (FCF) is the amount of cash flow available to investors (creditors and
owners) after the firm has met all operating needs and paid for investments in net
fixed assets and net current assets

FCF = EBIT x (1-T) + Dep/Amort – Capex – d WC

FCF = NOPAT + Dep/Amort – Capex – d WC

 Simple FREE CASH FLOW CALCULATION

Sales 1000
- Total Costs (600)
-
= Operating Profit 400
-
- Cash Taxes (100)
= Net Operating Profit After Tax 300
+
+ Depreciation 75
- Fixed Capital Investment (125)
-
- Incremental Working Capital (50)
-
Free Cash Flow (FCF) 200
Terminal Value Calcula/on
• Corporate poten8ally has an infinite life. The value is therefore the present
value of cash flow forever :

CFt
∞
Value = ∑ t
t =1 (1 + r )

• Since we cannot es/mate cash flows forever, we es8mate cash flows for a
growth period and then es/mate a Terminal Value, to capture the value at
the end of the period :

N
CFt Terminal Value
Value = ∑ t
+ N
t =1 (1 + r ) (1 + r )
Terminal Value = FCFn × (1 + g) ÷ (r – g)
DCF Choices: Equity Valua/on versus Firm Valua/on

4
 Es/ma/ng Growth

• The growth rate of a firm is driven by its fundamentals :

how much it reinvests and how high project returns are. As growth rates approach
“stability”, the firm should be given the characteris8cs of a stable growth firm.

• High growth firms usually : have high investment in fixed capital, have high risk, earn high
return on capital, and have low leverage.

• Stable growth firm usually : have lower investment in fixed capital, have average risk, earn
return on capital closer to WACC, and have leverage closer to industry average.

• Es/ma/ng growth :
– During forecast period (growth phase) : depends on size of firm, current growth rate,
barriers to entry and differen8al advantages.
– Aaer forecast period (sustainable growth) : no growth, or industrial growth rate
 Example : Corporate Value
Valuation date: 01/01/2015
Discounted Cash Flow Valuation
WACC: 11%
Perpetuity growth rate: 4%

2015 (Present) 2016F 2017F 2018F 2019F 2020F

Operating Income after Depreciation (1) Rp 102,688 Rp 126,032 Rp 171,619 Rp 187,978 Rp 201,604 Rp 201,604
Tax Rate (2) 44.3% 43.42% 43.42% 43.42% 43.42% 43.42%
Rp 54,724 Rp 74,518 Rp 81,621 Rp 87,537 Rp 87,537
Taxes (3=1*2) Rp 45,451
EBIAT (4=1-3) Rp 57,237 Rp 71,308 Rp 97,101 Rp 106,357 Rp 114,067 Rp 114,067

Depreciation and Amortization (5) Rp 56,113 Rp 87,661 Rp 91,786 Rp 94,593 Rp 97,355

Net Capital Expenditures (6) Rp (87,691) Rp (97,205) Rp (96,971) Rp (96,811) Rp (106,647)
Change in Net Working Capital (7) Rp (1,435) Rp (5,762) Rp (27,705) Rp (17,702) Rp (23,145) Rp (23,145)
Free Cash Flow (4+5+6+7) Rp 24,224 Rp 56,002 Rp 64,211 Rp 86,437 Rp 81,630 Rp 90,922

Discounting Period (1 year) - 1.00 2.00 3.00 4.00 5.00

Present Value Rp 24,224 Rp 50,452 Rp 52,115 Rp 63,202 Rp 53,772 Rp 53,958
Present Value of Cash Flows Rp 243,765

Terminal Value (TV) TV= Rp1,350,840

Present Value of Terminal Value (PVTV) Rp 801,658

Total Corporate Value Rp.1,045,423

Rp 1,099,381
 FCFF vs FCFE
In M&A, the pricing of the target will be valued with FCFE

FCFE = FCFF – Debt (interest bearing)

 When DCF Valuation Works Best
• This approach is easiest to use for assets (firms) whose
Ø cashflows are currently posi<ve and
Ø can be es<mated with some reliability for future periods, and
Ø where a proxy for risk that can be used to obtain discount rates is
available.

• It works best for investors who either:

Ø have a long <me horizon, allowing the market 8me to correct its
valua8on mistakes and for price to revert to “true” value or
Ø are capable of providing the catalyst needed to move price to value, if
you were an ac8vist investor or a poten8al acquirer of the whole firm
Market Approach : Rela/ve Valua/on using Mul/ples

• The most convenient method, and it uses financial mul8ples of comparable firms to
determine shareholder (equity) value or enterprise* (corporate) value.
– Price-to-Earnings Ra8o (P/E)
– Price-to-Earnings Before Interest and Taxes (P/EBIT)
– Price-to-Earnings Before Interest, Taxes, Deprecia8on and Amor8za8on (P/EBITDA)
– Price-to-Sales (P/Sales)
– Price-to-Book Value (P/BV)
– Price-to-Cash Flow From Opera8on (P/CFFO)
– Enterprise Value-to-Sales (EV/Sales)
– Enterprise Value-to-Produc8on Capacity (EV/Capacity)

*Corporate Value
= Value of Equity + Value of Debt
 Mul/ples for Fundamental Analyst

• Presen8ng finding on a rela8ve valua8on basis will make it

more likely that the findings / recommenda8ons will reach a
recep8ve audience.

• In some cases, rela8ve valua8on can help find weak spots in

discounted cash flow valua/on and fix them. (sanity check).

• The problem with mul8ples is not in their use but in their

abuse. If we can find ways to frame mul8ples right, we should
be able to use them befer.
Rela/ve Valua/on
Using the Mul/ples Right
PBV ra/o
High Low

High A B

PE ra/o Low
C D

Interpreta/on Matrix
Using the Mul/ples Right

High Overvalued

PBV ra/o

Low Undervalued

Low High

ROE – Cost of Equity

Interpreta/on Matrix
 Valuation Model – Market Approach with Multipl
Commonly Used Multiples Based on Industry

Industry Sub-Sector Commonly Used Multiples

Automotive Manufacture P/Sales

Components P/CFFO, P/Sales

Financial Services Banking P/BV

Insurance P/AV

Pulp and Paper P/BV

Chemical EV/EBITDA, EV/Sales, P/CFFO

Metal and Mining EV/EBITDA

Building and Construction EV/FCF, PER, EV/EBITDA

(including Cement) EV/Capacity

Food and Beverages Food Production EV/EBITDA, EV/CFFO

Cigarettes PER, Return on Capital Employed
Beverages EV/EBITDA, P/BV, EV/Sales

Oil and Gas Integrated PER, EV/CFFO

 When Relative Valuation Works Best

• Easiest to use when:

Ø there are a large number of assets comparable to the one being valued
Ø these assets are priced in a market
Ø there exists some common variable that can be used to standardize the
price

• Work best for investors:

Ø who have relatively short time horizons
Ø are judged based upon a relative benchmark (the market, other portfolio
managers following the same investment style etc.)
Ø can take actions that can take advantage of the relative mispricing; for
instance, a hedge fund can buy the under valued and sell the over valued
assets