Chapter 9

Alternative Approaches
to Valuation
 Introduction to Valuation
 Valuation critical in M&As
• Aids evaluation of acquisition candidates
• Helps to set goals and benchmarks
 Framework essential to discipline valuation
estimates
• Comparables (Companies, Transactions)
• Discounted Cash Flow (Spreadsheet, Formula)
• Use of multiple methods offers differing
perspectives
 Valuation should be guided by a business
economics analysis of the firm and its
environment
Chapter 9-2
 Comparables Approaches
 Comparables Analysis
• Use companies (or transactions) comparable in:
– Size and products
– Recent trends and future prospects
• Key ratios calculated for each company
• Key ratios are averaged for group
• Average ratios applied to absolute data for
company of interest
• Applying ratios yields indicated market values
• Valuation judgments are made

Chapter 9-3
 Comparables Approaches
 Advantages of comparables
• Common sense approach
• Marketplace transactions are used
• Widely used in legal cases, fairness evaluation,
etc.
• Allows valuation of private firms
 Limitations
• May be difficult to find companies comparable
by key criteria
• Ratios may differ widely for comparables
• Different ratios may give widely different
results
Chapter 9-4
Comparable Transactions Example
 Valuation based on companies involved
in similar merger transaction
 May be difficult to find truly similar
transactions within relevant time period
 Illustration of comparable transactions
for Exxon Mobil merger
• Average ratios suggest value of $56.8B
for Mobil (deal was for $71.4B)
• May not take into account synergies and
other unique factors
Chapter 9-5
 Comparable Transactions Example
Comparable Transaction Ratios
Amoco Texaco Conoco Average
Total Paid/Sales 1.38 0.77 0.37 0.84
Total Paid/Book 3.00 2.79 2.29 2.69
Total Paid/Net Income 22.46 15.46 7.60 15.18
Premium Paid, % Target 22.3% 17.7% 0.0% 13.3%
Premium Paid, % Combined 7.7% 6.3% 0.0% 4.7%

Chapter 9-6
 Comparable Transactions Example
Application of Valuation Ratios to Mobil
(Dollar Amounts in Billions)
Average Value of
Mobil Transaction Multiple Equity
LTM Sales $63.0 0.84 $53.0
Book Value $19.0 2.69 $51.2
LTM Net Income $2.9 15.18 $43.8
Market Value Target* $58.7 13.3% $66.5
Market Value Combined** $233.7 4.7% $69.6
Average = $56.8
* Value of equity = market value target x (1 + average premium paid, % target)
** Value of equity = market value combined x (1 + average premium paid, % combined)
- market value buyer

Chapter 9-7
Comparable Transactions Example
 Previous results similar to those of advisory
investment banks
 Comparables often fail to arrive at definitive
values – companies differ in:
• Revenue growth rates
• Growth of cash flows
• Riskiness (beta)
• Stage in the life cycle of industry or firm
• Competitive pressures
• Opportunities for expansion
• All of the above are difficult to assign a ratio
for appropriate comparable valuation
Chapter 9-8
 Capital Budgeting Decisions
 Process of planning expenditures whose
returns extend over a period of time
 An acquisition is fundamentally a capital
budgeting problem: negative NPV
mergers do not make sense (usually)
n CFt n It
NPVo = ∑ −∑ where :
t =1 (1 + k ) t =1 (1 + k )
t t

CFt = cash flows in period t

k = cost of capital
n = number of periods
I t = investment outlays in period t Chapter 9-9
 Real Options Analysis
 NPV may not recognize flexibility of
postponement, abandoning, etc.
 Value of flexibility may make some negative
NPV project positive
 Example: Negative NPV project
Postpone $ 50 million investment until Year 2
PV of incremental cash flows = $40 million
Cost of capital = 10%
$50 $50
NPV = $40 − 2
= $40 −
(1.10) 1.21
= $40 − $50(0.8264)
= 40 − $41.322
NPV = $ − 1.322 million Chapter 9-10
 Real Options Analysis
 Example: View as a call option
C = S N (d1 ) − Xe − rF T N (d 2)
C ≈ +$1.3 million
Real Option Variable Call Option Value

Present Value of Incemental Cash Flows S Current Stock Price $40 million

Investment to Create the Option X Exercise Price $50 million

Volatility of Cash Inflows σ Stock-Price Volatility 20%

Life of Option T Life of Option 2 years

Risk-Free Rate of Return rF Risk-Free Rate of Return 3.70%

Chapter 9-11
 DCF Spreadsheet Methodology
 Procedure
• Historical data for elements of financial
statements are presented for 5 to 10 years
• Financial analysis is performed to determine
ratios and patters
• Analysis of business economics of industry
• Based on analysis, relevant cash flows are
forecast
• Cash flows are then discounted to obtain
present values
• These present values are summed to arrive at an
Net Present Value (NPV)
Chapter 9-12
 DCF Spreadsheet Methodology
 Advantages
• Spreadsheets allow great flexibility in
projections
• Expresses calculations in recognizable financial
statements
 Disadvantages
• Projected numbers may create the illusion that
they are “actual” numbers
• May have a disconnect between business logic
and projections
• Complexity of spreadsheets may obscure
important driving factors
Chapter 9-13
 DCF Spreadsheet Methodology
Example: Basic Valuation of a Target
1 2 3 Terminal
1 Before-tax cash flows (Xt) 240 288 346 346
2 Less: Taxes at 40% (T) 96 115 138 138
3 After-tax cash flows [Xt(1-T)] 144 173 207 207
4 Less: Investments (It) 120 144 173 0
5 Free cash flows [Xt(1-T)-It] 24 29 35 207

6 Discount factors (1+k) (1+k)2 (1+k)3 k(1+k)3

6a Discount factors 1/1.10 1/1.21 1/1.331 10/1.331
7 Present values $21.82 $23.97 $26.30 $1,555.22

Chapter 9-14
 Cost of Capital
 Cost of equity
• Yield on equity must be greater than bond yield
(usually by 3 to 5 percent)
• Capital Asset Pricing Model (CAPM) is most
widely used
– Required return=risk return+risk component
Cost of equity = R f + β ( Rm − R f )
– Rf = risk free rate = usually return on long-
term US government bonds
– Rm-Rf = market equity premium = usually
long-term market return less risk free rate
– Beta = measures return on stock vs. market
return Chapter 9-15
 Cost of Capital
 Cost of debt
• Should be calculated on after-tax basis to
reflect deductibility of interest payments
• After-tax cost of debt = kb(1-T)
– T = corporate tax rate
– kb = pre-tax cost of debt
• Determining before tax-cost of debt
– Weighted average of yield to maturity of
publicly traded bonds
– Find bond rating of firm and associated yield
Chapter 9-16
 Cost of Capital
 Weighted Average Cost of Capital (WACC)
• First, determine the appropriate capital structure
of firm
– Should consider book ratios, market value
ratios, and industry comparables
– Target financing proportions should reflect
best judgment of firm’s financial structure in
the future
• Apply financing proportions (B/V, S/V) to cost
of equity (ks) and cost of debt (kb[1-T])
• WACC = k = kb(1-T)(B/V)+ks(S/V)
Chapter 9-17
 Capital Structure
 A critical element in WACC
 The use of debt
• Interest deductibility encourages debt financing
• But high debt levels increase risk of financial
distress, cause higher bond ratings, and increase
cost of debt
 Leverage and the firm’s beta
• High leverage increases firm’s levered beta
• Equation calculates target leverage ratio (B/S)
based on a target levered beta (ße), starting from
the firm’s unlevered equity beta (ßu) (business risk
of firm) B(1 − T )
• β e = β u 1 + 

 S  Chapter 9-18
 Capital Structure
Figure 9.1
Effects of Bankruptcy Costs and Taxes on the Cost of Capital
Percent
k e with bankruptcy costs

WACC with taxes and

bankruptcy costs

ku k b with bankruptcy costs

(1-T )k b
B
S
Optimal Capital Structure Chapter 9-19
 Formula Methodology
 Formula method is simply a compact
expression of spreadsheet method
• Both use discounted cash flow analysis
• Formula approach helps focus on underlying
drivers of valuation
 Key variables and relationships
• Revenues (Rt) – basic driver of firm value
• Growth rate (g) – rate of change in revenues
• Net operating income margin (m) – revenues
less COGS, selling, general and administrative
expenses, depreciation expenses
• Actual tax rate (T)
Chapter 9-20
 Formula Methodology
 Key variables and relationships
• Investment (It) – change in total capital
(working capital and fixed assets) over previous
period (as a ratio of revenues)
• Number of periods of supernormal growth (n) –
period when firm expects to maintain a
competitive advantage
• Cost of capital (k) – based on determination of
appropriate WACC
• Best judgment may be that terminal period
variables will differ from supernormal period
values
Chapter 9-21
 Formula Methodology
Formulas for Free Cash Flow Valuation of a Firm
No growth:

R0 [m(1 −T )]
V0 = for k >0
k

Constant growth:

R0 (1 +g ) [m(1 −T ) −I ]
V0 = for k >0
k −g

Temporary supernormal growth, then no growth:

n
(1 +g ) t R0 (1 +g ) n [m(1 −T )]
V0 = R0 [m(1 −T ) −I ] ∑ +
t =1 (1 +k ) t
k (1 +k ) n

Temporary supernormal growth, then constant growth:

n
(1 +g s ) t R0 (1 +g s ) n [m(1 −T ) −I c ] (1 +g c )
V0 = R0 [m(1 −T ) −I s ] ∑ + ⋅
t =1 (1 +k ) t
(1 + k ) n
( k −g c ) Chapter 9-22
 Formula Methodology
 Sensitivity analysis
• Easily executed using formula methods
• Can check range of alternative
possibilities
Variable Valuation effect of increasing
g +
I –
m +
k –
n +
T – Chapter 9-23
 Formula Methodology
 Limitations of the formula approach
• Less flexibility in reflecting forecasts for
individual years
• Calculations use financial statement data not
directly shown in the formulas
• More difficult to pinpoint calculation errors
than the spreadsheet approach
• In many cases, the second term or terminal
value will represent the bulk of a firm’s
valuation – practitioners must be careful with
assumptions impacting this term

Chapter 9-24