Applying Relative, Asset Oriented,

and Real Option Valuation Methods to

Mergers and Acquisitions

Chapter 8

1
 Learning Objectives¹
• Primary learning objective: To provide students with knowledge of
alternatives to discounted cash flow valuation methods, including
– Market Approach – Similar to real estate valuations
• Comparable companies
• Comparable transactions
• Same industry or comparable industry
– Asset oriented approach
• Tangible book value
• Liquidation value
• Break-up value
– Cost approach
– Weighted average method
¹ See Website, Chapter 8, Alternate Valuation Ratios, Table 7, which discusses several
alternate Equity Valuation and Enterprise Valuation Ratios.

3
 Applying Market-Based (Relative
Valuation) Methods1
MVT = (MVC / IC) x IT

Where

MVC = Market value of the comparable company C

IC = Measure of value for comparable company C
IT = Measure of value for company T
(MVC/IC) = Market value multiple for the comparable
company

1 Comparable companies may include those with profitability, risk, and growth characteristics similar to the target firm.

4
 Relative Valuation¹
• Value of asset is compared to values assessed
by the market for similar or comparable asset.
• Requirements:
– Identify comparable assets and market values
– Convert market values to standardized values
creating price multiples.
– Compare relative values controlling for any
differences.
¹ Damodoran, Corporate Finance, New York University, Chapter 7
5
 Relative valuation is pervasive
• Most valuations on Wall Street are relative
valuations.
– Almost 85% of equity research reports are
based upon a multiple and comparables.¹
– More than 50% of all acquisition valuations are
based upon multiples
– Rules of thumb based on multiples are not only
common but are often the basis for final
valuation judgments.
¹ Another study indicates 10:1 in favor of relative comps.

6
 Relative valuation is pervasive
• While there are more discounted cash flow
valuations in consulting and corporate finance, they
are often relative valuations masquerading as
discounted cash flow valuations.
– The objective in many discounted cash flow
valuations is to back into a number that has been
obtained by using a multiple.
– The terminal value in a significant number of
discounted cash flow valuations is estimated
using a multiple.
7
 Valuation Ratios versus DCF¹
• Do both
• Both entail use of value estimates, professional
judgment, quality of information and purpose of
valuation.
• Acquisition of specific, known asset or company,
and good data, Comps may be better.
• Acquisition of general, non-specific or unknown
asset or company, DCF may be better.
¹ See Titman, Valuation-The Art and Science of Corporate Investment Decisions, 2011, pgs. 291-2.

8
 Market-Based Methods: Comparable Company Example
Exhibit 8-1. Valuing Repsol YPF Using Comparable Integrated Oil Companies
Target Valuation Based on Following Multiples (MV C/VIC):
Forward
Comparable Company Trailing P/E1 Price/Sales Price/Book
P/E2 Average
Col. 1 Col. 2 Col. 3 Col. 4 Col. 1-4
Exxon Mobil Corp (XOM) 11.25 8.73 1.17 3.71
British Petroleum (BP) 9.18 7.68 0.69 2.17
Chevron Corp (CVX) 10.79 8.05 0.91 2.54
Royal Dutch Shell (RDS-B) 7.36 8.35 0.61 1.86
ConocoPhillips (COP) 11.92 6.89 0.77 1.59
Total SA (TOT) 8.75 8.73 0.80 2.53
Eni SpA (E) 3.17 7.91 0.36 0.81
PetroChina Co. (PTR) 11.96 10.75 1.75 2.10
Average Multiple (MVC/VIC) Times 9.30 8.39 0.88 2.16
Repsol YPF Projections (VIT)3 $4.38 $3.27 $92.66 $26.49
Equals Estimated Value of Target $40.72 $27.42 $81.77 $57.32 $51.81
1
Trailing or Current 52 week average. 2Projected 52 week average. 3Billions of Dollars.

9
 Valuation ExxonMobil Chemical
• ExxonMobil, 3rd largest following BASF & DuPont
• Division earned $3.428 Billion
• Hypothetical – assume spin off of division.
– What is the baseline valuation? (Next slide - 10)
– Modify baseline to adjust for relative size. (Slide 11)
– Consider growth factors (Slide 12)

10
 Equity Valuation Using PE Ratios
Chemical Company P/E Ratios
Share Price ÷ EPS = P/E Ratio
BASF $ 70.47 $ 5.243 13.44
Bayer 35.64 1.511 23.59
Dow Chemical 47.40 4.401 10.77
DuPont 41.00 2.572 15.94
Eastman Chemical 51.69 5.75 8.99
FMC 59.52 5.729 10.39
Rohm & Hass 45.02 2.678 16.81
Average 14.28

11
 Market Cap and PE Ratios
P/E Ratio Market Cap (Billions)
BASF 13.44 $ 38.25
Bayer 23.59 25.63
Dow Chemical 10.77 45.25
DuPont 15.94 40.61
Eastman Chemical * 8.99 4.10
FMC * 10.39 2.20
Rohm & Hass * 16.81 10.01
Average (Big 4) 15.94 $37.44
Average (Small 3)* 12.06 5.44

12
 Variation of PE Ratio
Share Price Current Current/ Forecast Forward
EPS Trailing EPS P/E Ratio
P/E Ratio
BASF $ 70.47 $ 5.243 13.44 $ 7.27 9.69
Bayer 35.64 1.511 23.59 2.69 13.27
Dow 47.40 4.401 10.77 5.71 8.30
DuPont 41.00 2.572 15.94 3.04 13.48
Eastman 51.69 5.75 8.99 5.93 8.71
FMC 59.52 5.729 10.39 5.66 10.51
Rohm & 45.02 2.678 16.81 3.12 14.44
Hass
Average 14.28 11.20

13
 Valuation of ExxonMobil
• Baseline valuation
– Earnings $3.428B X P/E Ratio 14.28 = $48.94 B
• Modification to reflect relative size
– Earnings $3.428B X P/E Ratio 15.94 = $54.63 B
• Further modification
– Substantial dispersion (10.77 – 23.59) in P/E
Ratios even among top 4 firms indicate risk and
growth potential must be considered.

14
 Market-Based Methods:
Recent Transactions’ Method1
• Calculation similar to comparable companies’
method, except multiples used to estimate target’s
value based on purchase prices of recently
acquired comparable companies.
• Most accurate method whenever the transaction is
truly comparable and recent. Boston Beer IPO
• Major limitation is that truly comparable recent
transactions are rare.

Also called precedent method.

1

15
 Boston Beer Company
• Founded 1984 6th generation brewer (HBS)
• Drawn by European, more bitter brews.
• Not looking to compete with Budweiser etc.
• By 1994, largest craft brewer, grew 57%.
• 7 year round and seasonal beers.
• Boston Lager 63% of sales.
• European standards and raw materials.

16
 Boston Beer Company
• Used four contract breweries.
• Four initiatives
– High quality – 5 masters, “date passed, beer goes”
– Contract brewing – Pros and cons?
– Intensive marketing & sales – 40 ¢ of each $
– Product innovations - seasonal & private labeling
• Outlook
– Current growth – stagnant but craft beers grew
– Niche marketing and development?

17
 Boston Beer Company
• Competitors - SWOT
– Majors – AB Bev; Coors, Miller
– 2nd Tier – Strohs, Heileman, Genessee etc.
• Tough for them to fight the Big 3
• Loss of market share
• Excess capacity – How did this help BBC?
– Imports – German, Holland, Canada, Mexico.
Subsequent changes due to M&A ie. Molson/Coors
– Craft breweries – far and away, the smallest

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 Boston Beer Company
• Craft Brewing – smallest; rapid growth -40%
– Very competitive, proprietary recipes
– Catered to upscale market therefore expensive
– Four types
• Brewpubs (12%) - product consumed on site
• Micro (22%) – limited distribution < 15,000 bbls
• Regional (30%)- limited distribution, capital intensive,
limited marketing, brand recognition
• Custom (36%) – Typically contract, less capital
intensive therefore more marketing $
19
 Boston Beer Company
• Recent IPOs:
– Redhook – two plants, planning a third, allied with Bud in NH
using distribution network. 41% growth Now Craft Brewers
Alliance. $6.84 share price 10/5/11
– Pete’s – Contract brewer, allied with Strohs, planned to build
brewery. Now Pete’s Wicked Brewing. Private. Affiliated with
Gambrinus, importers Moosehead, Corona
– Further characteristics – See previous slides
– Questions and Issues from the “Market”:
• Positive reception – how well/how long? Hula hoop?
• Age old question of sustainable growth.
• Dependence on 2nd tier breweries?
20
 Boston Beer IPO Calculation
Boston Beer IPO Stock Price

Can we use Pete's or Red Hook off ering information in Ex 3 as a guide?

1. P/E Ratio = Price/EPS = Multiple

2. Hypothetical Price

1994 ?/.29=100 $29

1995 ?/.35* =100 * .26 annualized $35

3. Apply issue discount

1st day close $25

Offer Price ($18)

$7 -0.39 rate

4. Average stock price = 29+35/2= $32 X 61% = $20

21
 Boston Beer IPO
• November 21, 1995 , BBC issues 2.9 million
shares at $20 each.
• Price by end of day rose 50% to $30.75.
• Today’s Price $80.49. Earlier this year,
$100.93.

22
 Market-Based Methods:
Same or Comparable Industry Method

• Multiply target’s earnings or revenues by

market value to earnings or revenue ratios
for the average firm in target’s industry or a
comparable industry.
• Primary advantage is the ease of use and
availability of data.
• Disadvantages include presumption
industry multiples are actually comparable
and analysts’ projections are unbiased.
23
 PEG Ratio = PE Ratio/Earnings Growth
• Used to adjust relative valuation methods for differences in growth rates among
comparable firms.
• Many current models assumes zero or minimal growth
• BES/CPS example: BES/CPS 15 & 9% respectively vs industry 12.4 & 11%.
• Helpful in determining which of a number of different firms in same industry
exhibiting different growth rates may be the most attractive.
(MVT/VIT) = A and
VITGR

MVT = A x VITGR x VIT

Where A = Market price to value indicator relative to the growth rate of
value indicator (e.g., (P/E)/ EPS growth rate)
MVT = Market value of target
VIT = Value indicator for target (e.g., EPS)
VITGR = Projected growth rate in value indicator (e.g., EPS)

24
 Applying the PEG Ratio

An analyst is asked to determine whether Basic Energy Service (BAS) or Composite Production
Services (CPS) is more attractive as an acquisition target. Both firms provide engineering,
construction, and specialty services to the oil, gas, refinery, and petrochemical industries.
BES and CPS have projected annual earnings per share growth rates of 15 percent and 9
percent, respectively. BES’ and CPS’ current earnings per share are $2.05 and $3.15,
respectively. The current share prices as of June 25, 2008 for BES is $31.48 and for CPX is $26.
The industry average price-to-earnings ratio and growth rate are 12.4 and 11 percent,
respectively. Based on this information, which firm is a more attractive takeover target as of the
point in time the firms are being compared?

Industry average PEG ratio:1 12.4 (PE Ratio) /.11 (Growth rate of earnings) = 112.73
BES: Implied share price = 112.73 x .15 x $2.05 = $34.66 10.1% undervalued
CPX: Implied share price = 112.73 x .09 x $3.15 = $31.96 22.9% undervalued
Answer: The difference between the implied and actual share prices for BES and CPX is $3.18
(i.e., $34.66 - $31.48) and $5.96 ($31.96 - $26.00), respectively. CPX is more undervalued than
BES at that moment in time.
1
Solving MVT = A x VITGR x VIT using an individual firm’s PEG ratio provides the firm’s current or share price in period T, since this
formula is an identity. An industry average PEG ratio may be used to provide an estimate of the firm’s intrinsic value. This implicitly
assumes that both firms exhibit the same relationship between price-to-earnings ratios and earnings growth rates.

25
 Asset-Based Methods:
Tangible Book Value
• Tangible book value (TBV) = (total assets - total
liabilities - goodwill)
• Target’s estimated value = Target’s TBV x
[(industry average or comparable firm market
value) / (industry or comparable firm TBV)].
• Often used for valuing
– Financial services firms where tangible book
value is primarily cash or liquid assets
– Distribution firms where current assets
constitute a large percentage of total assets
• Remember impact of GAAP = historical cost
26
 Valuing Companies Using Asset Based Methods
Ingram Micro distributes information technology products worldwide. The firm’s share price on
8/21/08 was $19.30. Projected 5-year annual net income growth is 9.5% and the firm’s beta is
.89. Shareholders’ equity is $3.4 billion and goodwill is $.7 billion. Ingram has 172 million (.172
billion) shares outstanding. The following firms represent Ingram’s primary competitors.

Market Value/ Beta¹ Projected 5-Year

Tangible Book Value Net Income Growth
Rate¹ (%)
Tech Data .91 .90 11.6

Synnex Corporation .70 .40 6.9

Avnet 1.01 1.09 12.1

Arrow .93 .97 13.2

Based on this information, what is Ingram’s tangible book value per share (VI T)? What is the
appropriate industry average market value to tangible book value ratio (MV IND/VIIND)? Estimate
the implied market value per share for Ingram (MV T) using tangible book value as a value
indicator. Based on this analysis, is Ingram under-or-overvalued compared to its 8/21/08
share price?
¹ Note both Beta and 5 Year Growth Rate used to cull out “irrelevant” Company. 27
 Solution to Ingram Problem
• Ingram’s net tangible book value per share (VIT) = ($3.4 -$.7)/.172 = $15.70¹

• Based on risk as measured by the firm’ beta and the 5-year projected earnings
growth rate, Synnex is believed to exhibit significantly different risk and growth
characteristics and is excluded from the calculation of the industry average
market value to tangible book value ratio. Therefore, the appropriate industry
average ratio is as follows:

MVIND/VIIND = .95 [i.e., (.91+1.01+.93)/3]

• Ingram’s implied value per share = MVT = (MVIND/VIIND) x VIT = .95 x $15.70 = $14.92

• Based on the implied value per share, Ingram was over-valued on 8/21/08 when its
share price was $19.30
¹ Note, we are deriving tangible book value by assuming it equals equity less intangible assets (goodwill). The
better approach would be to review or project NBV from financial statement.

28
 Asset-Based Methods: Liquidation Method
• Value assets as if sold in an “orderly” fashion (e.g., 9-12
months) and deduct value of liabilities and expenses
associated with asset disposition. Used in Chapter 7/11
Bankruptcy Cases.
• While varies with industry,
– Receivables often sold for 80-90% of book value
– Inventories might realize 80-90% of book value
depending on degree of obsolescence and condition
– Equipment values vary widely depending on age and
condition and purpose (e.g., special purpose)
– Book value of land may understate market value
– Prepaid assets such as insurance can be liquidated with
a portion of the premium recovered.

29
 Asset-Based Methods:
Liquidation Method
• Nortel Networks – Canadian Company
– July 1, 2011 pursuant to Bankruptcy
– Sold 6,000 patents for $4.5 Billion at auction to
Rockstar Bidco.
– Consortium Apple, EMC, Microsoft, RIM & Sony
– Google – defensive, stalking horse bid to
discourage suits over Android & Chrome.
– Intel – early bidder but teamed with Google

30
 Asset-Based Method: Break-Up Value
• Target viewed as series of independent operating units,
whose income, cash flow, and balance sheet statements
reflect intra-company sales, fully-allocated costs, and
operating liabilities specific to each unit
• After-tax cash flows are valued using market-based
multiples or discounted cash flows analysis to determine
operating unit’s current market value
• The unit’s equity value is determined by deducting
operating liabilities from current market value Mkt. Cap
• Aggregate equity value of the business is determined by
summing equity value of each operating unit less
unallocated liabilities and break-up costs
• May be used by private equity/hedge and LBO deals.
31
 McGraw Hill Spin Off ?¹
• August 2011 – Publisher & S&P owner
• Pressure from activist hedge fund Jana Partners and
Ontario Teachers’ Pension Plan.
• Meetings between MH (Goldman) & Jana
• MH –”mini conglomerate of non related information
businesses”. “Education – capital intensive and plodding
growth”?
• Lazard & JPMorgan Chase – breakup value $55 per
share versus $41 current price.
¹ See website, McGraw Hill Faces Breakup Pressures, Business Week, August 2, 2011 .
32
 Replacement Cost Method
• All target operating assets are assigned a value
based on what it would cost to replace them.
• Each asset is treated as if no additional value is
created by operating the assets as part of a
going concern.
• Each asset’s value is summed to determine the
aggregate value of the business.
• This approach is limited if the firm is highly
profitable (suggesting a high going concern
value) or if many of the firm’s assets are
intangible.

33
Weighted Average Valuation Method
An analyst has estimated the value of a Estimated Relative Weighted
company using multiple valuation Value ($M) Weight Avg. ($M)
methodologies. The discounted
cash flow value is $220 million, 220 .30 66.0
comparable transactions’ value is
$234 million, the P/E-based value is
$224 million and the liquidation 234 .40 93.6
value is $150 million. The analyst
has greater confidence in certain
methodologies than others. 224 .20 44.8
Estimate the weighted average
value of the firm using all valuation
methodologies and the weights or 150 .10 15.0
relative importance the analyst gives
to each methodology.
1.00 219.4

34
 Real Options as Applied to M&As
• Real options refer to management’s ability to adopt and later revise
corporate investment decisions (e.g., acquisitions) - Genzyme
• Options to expand (i.e., accelerate investment)
– Acquirer accelerates investment in target after acquisition completed
due to better than anticipated performance of the target
• Options to delay (i.e., postpone timing of initial investment)
– Acquirer delays completion of acquisition until a patent pending
receives approval
• Options to abandon (i.e., divest or liquidate initial investment)
– Acquirer divests target firm due to underperformance and recovers a
portion of its initial investment

35
 Alternative Real Option
Valuation Methods
• Develop a decision tree for which the NPV of each
“branch” represents the value of alternative real options.
The option’s value is equal to difference between its NPV
and the NPV without the real option. Art or science?
• Treat the real options as financial options and value using
the Black-Scholes method.
– Option to expand or delay are valued as call options and
added to the NPV of the investment without the option.
– Option to abandon is valued as a put option and added
to the NPV of the investment without the option.

36
 Analyzing Microsoft’s Real Options in
Its Attempted Takeover of Yahoo – “handicapping”
Option to expand
Option to expand
contingenton
contingent on
successful
successful
integrationofofYahoo
integration Yahoo
&&MSN
MSN

PurchaseYahoo
Purchase Yahoo
online search
online search
businessonly.
business only.Buy
Buy
remaining
remaining
Base Case: Option to postpone businesses later.
Base Case: Option to postpone businesses later.
Microsoft offers to contingent on
Microsoft offers to contingent on
buy all outstanding Yahoo’s rejection of Offer same/lower
buy all outstanding Yahoo’s rejection of Offer same/lower
shares of Yahoo offer price for all of
shares of Yahoo offer price for all of
Yahoo if board
Yahoo if board
composition
composition
changes
changes
Spin-off combined
Spin-off combined
Yahoo&&MSN
Yahoo MSNtoto
Microsoft
Microsoft
Option to abandon shareholders
Option to abandon shareholders
contingent on failure
contingent on failure
to integrate Yahoo
to integrate Yahoo
& MSN
& MSN
Divest combined
Divest combined
Yahoo & MSN. Use
Yahoo & MSN. Use
proceeds to pay
proceeds to pay
dividend or buy
dividend or buy
back stock. 37
back stock.