lecture about Corporate Governance in an M&A context

Lecture about Corporate Governance in M&A

1. Mergers and Acquisitions and corporate governance ValuatioN 1

2. Reasons for Business Valuations Acquisitions: Valuing a target company By competing potential acquirers … but also the target to guide their reaction on an offer Other reasons for business valuations: IPOs: Going public and valuing stock Shareholder lawsuits Buy-sell agreements Matrimonial litigation Damages litigation M&A and Corporate Governance 2

3. Rational behind Valuation Value of business = future benefits derived from a business Steps in valuation of benefits process: Project future benefits from business Projection process may utilize historical data Determine present value of future benefits M&A and Corporate Governance 3

4. Science or art? Scientific … standard methods and hard data to consider in the formulation of valuation. or Art ? … different methods may be employed in a given evaluation. different methods may provide different business values gives the impression that the general methodology lacks systematic rigor The naive reader may infer that the valuation of businesses may be an overly subjective process However, … objective valuations can be achieved by paying close attention to the assumptions/methodologies used. M&A and Corporate Governance 4

5. Benchmarks of value To test the accuracy of the valuation can be checked through a basic sensibility check Compare the valuation result with a benchmark: “floor value of the company” Minimum value that the company should command in the market place What benchmarks do we have at hand … Book value Equity value Enterprise value Liquidation value M&A and Corporate Governance 5

6. Benchmarks of value Book value (a.k.a. shareholders equity, net assets, or net worth) Book value of assets – liquidation costs (of liabilities and preferred stock) Does not include intangible assets that are not on the books Not the true value of the company Equity value Market capitalization or simply the value of the firm’s stock M&A and Corporate Governance 6

7. Benchmarks of value Enterprise value Value of the entire business Value to equity and debt holders Liquidation value Another benchmark for the company’s floor value Value after liquidation of assets and payment of liabilities M&A and Corporate Governance 7

8. Due diligence in business valuation Economic analysis Macroeconomic analysis Trends in macroeconomic aggregates: GDP Personal income Unemployment Retail sales Consumer confidence Manufacturing output Trend analysis of economic condition of region Examine regional economic aggregates M&A and Corporate Governance 8

9. Industry analysis Trend analysis of industry Historical growth Age of industry Competitiveness of industry - impact of profit margins Regulation Recent relevant changes Deregulation New innovation Marketing techniques and costs M&A and Corporate Governance 9

10. NPV for capital budgetting The net present value = the discounted future cash flows (or earnings) minus the investment to purchase the target firm. The discounted future cash flows approach to valuing a business is based on projecting the magnitude of the future monetary benefits that a business will generate. Similar to NPV calculation used for capital budgetting (covered in any corporate finance textbook) M&A and Corporate Governance 10 Where: FB i = Future benefit in year i r = discount rate (WACC) I = Investment at time 0

11. DCF to value a business Two-part process: Part one: forecast cash flows for a period over which the evaluator feels comfortable about the accuracy of the forecast Typically 5 years in length Referred to as the discrete period Part two: Value the remaining cash flows as a perpetuity. Referred to as the continuing or terminal value BV = Value derived from the discrete period + Value of the terminal value This value can then be computed as follows: M&A and Corporate Governance 11 Where: BV = Value of the business FCF i = free cash flow in the i th period g = growth rate in future cash flows after the 5 th year

12. Continuing or terminal value The continuing value (CV) represents the value that the business could be expected to be sold for at the end of the specific forecast period We measured this value by treating it as a perpetuity and capitalizing the remaining cash flows, which we assumed were going to grow at a certain growth rate Sensitive to the growth rate that is used! Different growth rate assumptions can change the resulting value significantly Example: FCF at end period is $10 million, discount rate of 11%, and growth rate of either 5% or 6% CV 1 = $10,000,000 (1.06)/(0.11-0.06) = 212,000,000 CV 2 = $10,000,000 (1.05)/(0.11-0.05) = 175,000,000 Difference in continuing value of 21% (not been discounted back to year 0 terms) M&A and Corporate Governance 12

13. Classic example of overpaying – Snapple by quaker oats In 1994, Quaker Oats had acquired Snapple for $1,7 billion Two companies in the food and beverage products industry In 1997, Quaker Oats sold Snapple to Triac Cos for $300 million Quaker spokesman Mark Dollins said. “Unfortunately, … [Snapple] did not grow at the rate we anticipated.” Background: Snapple has impressive growth before the acquisition Snapple used its prior growth to demand a high premium (as it should have done) Quaker did not realistically evaluated Snapple’s growth prospects Should have used more modest growth rate when it valued the company Proper economic analyses, industry and macro analyses could have prevented this M&A and Corporate Governance 13

14. Assumptions 2017 sales level: $2.5 billion Sales growth: 10% declining to 6% after 5th year (see details table next slide) WACC = 12% Net op. cap. expense/sales = 5% After tax operating margin = 6% Market value of debt= 100 mill. Shares outstanding: 40 Formulas you need NOPAT= EBITx (1-tax rate) FCF= NOPAT- Δ net in operating assets or FCF= NOPAT - new net op. capital expenditures Case study: dcf M&A and Corporate Governance 14

15. Value of debt Case study: dcf Enterprise value: 496.2; Value of common equity: 496.2-100=396.2; Value of stock: 396.2/40=9.9 M&A and Corporate Governance 15 1 2 3 4 5 Sales growth rate 10% 9.5% 9% 8% 7% After tax operating margin 6% 6% 6% 6% 6% Net op. cap. Exp.%/sales 5% 5% 5% 5% 5% WACC 12% Base level sales 2017 (in $ mill.) 2,500 1 2 3 4 5 6 (TV) Sales (in $ mill.) 2,750 3,011.3 3,282.3 3,544.8 3,793 4,020.58 NOPAT 165 180.7 196.9 212.7 227.6 241.2 Net op. cap. Exp 137.5 150.6 164.1 177.2 189.6 201 FCFs 27.5 30.1 32.8 35.4 37.9 40.2 PV FCFs 24.6 24 24.4 22.5 21.5 380.2 40,2/(0.12-0,06) / 1.12 5 You might find slightly different results due to rounding!

16. Dcf valuation Advantages of using the DCF method The model allows for changes in cash flows in the future The cash flows and estimated value are based on forecasted fundamentals The model can be adapted for different situations Disadvantages of using the DCF method Estimating future cash flows is difficult because of the uncertainty Estimating discount rates is difficult, and these rates may change over time Ideally, a range of plausible valuations under different scenarios should be presented The terminal value estimate is sensitive to the assumptions and model used M&A and Corporate Governance 16

17. Valuation of synergies M&A and Corporate Governance 17

18. What is a synergy, again? “Synergy is the additional value that is generated by combining two firms, creating opportunities that would not been available to these firms operating independently” Most widely ( mis -) used rationale in M&As Two broad categories: Operating synergies, e.g. economies of scale, higher pricing power, higher growth potential Show up as higher expected cash flows Financial synergies, e.g. tax benefits, diversification, uses for excess cash… Higher cash flow or lower discount rate M&A and Corporate Governance 18 Source: http://people.stern.nyu.edu/adamodar/pdfiles/papers/synergy.pdf

19. How can or should we value synergies Three steps Value acquirer and target independently Estimate value of combined firm with no synergy Incorporate the effects of synergy into the valuation model to value the combined firm with synergy Difference (3)-(2) gives us the value of the synergy M&A and Corporate Governance 19 Source: http://people.stern.nyu.edu/adamodar/pdfiles/papers/synergy.pdf

20. Valuing synergies: P&G acquires Gillette in 2004 Three steps Value acquirer and target independently Estimate value of combined firm with no synergy Incorporate the effects of synergy into the valuation model to value the combined firm with synergy Difference (3)-(2) gives us the value of the synergy M&A and Corporate Governance 20 Source: http://people.stern.nyu.edu/adamodar/pdfiles/papers/synergy.pdf

21. P&G standalone valuation 1 2 3 4 5 TV Sales growth rate 7.45% 7.45% 7.45% 7.45% 7.45% 4.25% After tax operating margin 12.5% 12.5% 12.5% 12.5% 12.5% 12.5% Net op. cap. Exp .%/sales 5% 5% 5% 5% 5% 8% WACC 7.3% 7.3% 7.3% 7.3% 7.3% Base level sales 2004 (in $ mill.) 56,741 M&A and Corporate Governance 21 1 2 3 4 5 TV Sales (in $ mill.) 60,968 65,510 70,391 75,635 81,270 84,724 NOPAT 7,632 8,200 8,811 9,468 10,173 10,605 Net op. cap. Exp 3,053 3,280 3,524 3,787 4,069 6,412 FCFs 4,579 4,920 5,287 5,681 6,104 4,193 Discount factor (1+WACC) t 1.073 1.151 1.235 1.326 1.422 1.422 PV FCFs 4,267 4,273 4,279 4,285 4,291 106,053 SUM PV FCF 127,450 Source: http://people.stern.nyu.edu/adamodar/pdfiles/papers/synergy.pdf 4,193/(0.073-0.0425)/1.073 5 This is rounded: To get to the value from the table use 12.5175% You might find slightly different results due to rounding!

22. Gillette Standalone valuation 1 2 3 4 5 TV Sales growth rate 8.02% 8.02% 8.02% 8.02% 8.02% 4.25% After tax operating margin 16.5% 16.5% 16.5% 16.5% 16.5% 16.5% Net op. cap. Exp.%/sales 8% 8% 8% 8% 8% 10% WACC 7.4% 7.4% 7.4% 7.4% 7.4% Base level sales 2004 (in $ mill.) 10,477 M&A and Corporate Governance 22 1 2 3 4 5 TV Sales (in $ mill.) 11,317 12,225 13,205 14,264 15,408 16,063 NOPAT 1,867 2,017 2,179 2,354 2,542 2,650 Net op. cap. Exp 905 978 1,056 1,141 1,233 1,526 FCFs 962 1,039 1,122 1,212 1,310 1,124 Discount factor (1+WACC) t 1.074 1.153 1.239 1.331 1.429 1.429 PV FCFs 896 901 906 911 917 25,060 SUM PV FCF 29,590 Source: http://people.stern.nyu.edu/adamodar/pdfiles/papers/synergy.pdf 1,124/(0.0739-0.0425)/1.074 5 This is rounded: To get to the value from the table use 7.39% You might find slightly different results due to rounding!

23. Value of combined firm ( p&G+Gillette ) Value of P&G: 127,450 Value of Gillette: 29,590 Combined value: 157,040 Keep in mind that is the value without synergies! Assumptions about the synergies of the combined company: Economies of scale  increase in after tax operating margin (approx. $ 200 mill. per year) Combined (levered) beta reduces cost of capital to 7.0% M&A and Corporate Governance 23 Source: http://people.stern.nyu.edu/adamodar/pdfiles/papers/synergy.pdf

24. Value of synergies 1 2 3 4 5 TV Sales (in $ mill.) 72,283 77,733 83,594 89,897 96,675 100,784 NOPAT +200 9,699 10,417 11,190 12,021 12,915 13,455 Net op. cap. Exp (const.) 3,958 4,258 4,581 4,928 5,302 7,938 FCFs 5,741 6,159 6,609 7,093 7,613 5,518 Discount factor (1+WACC) (lower) 1.07 1.14 1.23 1.31 1.40 PV FCFs 5,365 5,380 5,395 5,411 5,428 143,054 SUM PV FCF 170,033 M&A and Corporate Governance 24 Combined value (incl. synergies): 170,033 Combined value (no synergies): 157,040 Value synergy 12,997 (assuming that synergies can be realized immediately) Source: http://people.stern.nyu.edu/adamodar/pdfiles/papers/synergy.pdf You might find slightly different results due to rounding! 5,518/(0.07-0.0425)/1.07 5

25. Synergy and value M&A and Corporate Governance 25 Source: http://people.stern.nyu.edu/adamodar/pdfiles/papers/synergy.pdf

26. Comparable company analysis M&A and Corporate Governance 26

27. Comparable company analysis M&A and Corporate Governance 27

28. Common multiples most commonly cited multiple is the P/E ratio and EBITDA multiples P/E ratio which is the ratio of a company's stock price (P) divided by its earnings per share (EPS, or E for short) When we multiply a derived P/E ratio by a target company's EPS, we get an estimated stock price. EXAMPLE: 10 comparable companies - average P/E ratio is 17 the target company's EPS = $3: 17 × $3 = $41 EBITDA multiples = enterprise value divided by a given company's EBITDA level. Done for group of comparable companies to derive our average value Value is then applied to the target company's EBITDA value to obtain its enterprise value. Then back out the debt of the target from this value to get the value of its equity M&A and Corporate Governance 28

29. Example: Comparable Company Analysis Assuming that the average of the values from the different multiples is most appropriate: If the typical takeover premium is 20%, what is the XYZ Company’s value in a merger using the comparable company approach? Estimated takeover price of the XYZ Company = $237.5 million × 1.2 = $285 million M&A and Corporate Governance 29 Comparables’ Multiples Estimated Stock Value Earnings $10 million × 30 $300 million Cash flow $12 million × 25 $300 million Book value of equity $50 million × 2 $100 million Sales $100 million × 2.5 $250 million Average = $237.5 million

30. Do we like valuation ratios (comparative company multiples)? Easily applicable, even for firm outsiders Key issue using comparable multiples is (obviously) COMPARABILITY. Are the comparable companies from which we derived the multiple truly similar to the target being valued? Are they more valuable or less valuable? Industry comparison difficult because firms are really not comparable Market-based multiples are subject to stock market fluctuations M&A and Corporate Governance 30

31. Comparable transaction analysis M&A and Corporate Governance 31

32. Comparable Transaction Analysis Suppose an analyst has gathered the following information on the target company, the MNO Company: MNO Company Average of comparables Earnings $10 million P/E of comparables 15 times Cash flow $12 million P/CF of comparables 20 times Book value of equity $50 million P/BV of comparables 5 times Sales $100 million P/S of comparables 3 times Estimate the value of the MNO Company using the comparable transaction analysis, giving the cash flow multiple 70% and the other methods 10% each. $238 million The company analysis uses comparables that are similar but that may or may not be involved in M&A. The comparable transaction analysis uses multiples only of recent transactions of comparable companies.   M&A and Corporate Governance 32

33. Comparable Transaction Analysis Advantages Does not require specific estimation of a takeover premium Based on recent market transactions, so information is current and observed Reduces litigation risk Disadvantages Depends on takeover transactions being correct valuations There may not be sufficient transactions to observe the valuations Does not include value of specific changes to be made in target M&A and Corporate Governance 33

34. That is it Questions ? Email me [email protected] Or online office hours , Next Friday and Monday between 13 and 15 M&A and Corporate Governance 34