Valuing the Target Firm

MARKET CAPITALIZATION
In some situations the only completely objective value measure is
the market capitalization. This is equal to the number of outstanding
shares of common stock times the market price per share, assuming
the market price is observable and there are no complexities
in computing the number of outstanding shares. Any acquirer
would have to expect to pay a premium to the current market capitalization.
The market value of the common stock sets a floor for an
offering price by a buyer. Rarely would a buyer consider submitting
a bid less than current market price and expect to acquire a majority
of the outstanding shares. In fact, one would expect the acquirer to
have to pay a premium over the market price. Thus the market price
of the common stock is an important measure of value since it sets a
minimum-offering price.
It can be argued that, with a closely held corporation, if the
stockholders desire to unload their stock, they may not be able to,
because the market is too thin. In such a situation the seller might accept
the market price or even marginally less than the market price,
since the market price does not fairly represent the firm's value.
Can one obtain the value of the stockholders' equity by using
the market value for a few shares traded on the stock market? It
should be remembered that the entire universe of investors is available
as possible purchasers of the stock and that the present owners
are not bidding up the stock price to acquire more shares. Normally
it will not take a large price increase to cause the present investors
to sell their shares of stock assuming the price before the bid was set
by the market. Premiums paid by the acquirers in most deals are less
than .30.
MULTIPLIERS___________________________
The use of multipliers for valuation is common practice. A multiplier
is applied to some type of flow measure. The multiplier is frequently
based on the observed relationships of comparable firms.
The following multipliers are used:
■ Price-earnings multiplier.
■ Cash flow multiplier (EBITDA and free cash flow multipliers).
EBITDA is earnings before interest, taxes, depreciation, and
amortization.
Free cash flow is cash flow from operations after maintenance
capital expenditures. Sometimes free cash flow is computed
after all investment outlays.
■ Cash flow multipliers applied to the next period's flows (e.g.,
NEBITDA).
If one takes the current earnings and multiplies by the current
price-earnings multiplier, one obtains the current market
price. The expected earnings of the current year or an adjusted
earnings can be used rather than the observed earnings of the past
year. Another variation is to use the expected earnings of the next
year.
The use of the expected earnings times a price-earnings multiplier
is a common technique for evaluating prospective acquisitions.
It may be a shortcut method of applying discounted
cash flows. The following mathematical model illustrates this
position.
The price-earnings ratio (P/E) that is expected is equal to the
dividend payout rate (1 - b) divided by - g. The larger the
value of the growth rate (g), the larger the value of the P/E ratio
that will be justified.
Assume the P/E of comparable firms is computed to be 8 and
the earnings to the stockholders of the target firm are $10,000,000.
The valuation of the stock is $80,000,000. But the following complexities
exist:
■ Were the other firms really comparable?
■ Were the earnings really $10,000,000 or should
adjustments be made?
■ Does the firm have excess assets? ■
Does the firm have unrecorded liabilities?
■ Is there reason to expect that next year's earnings will differ
sig nificantly from $10,000,000? ■ Is the average P/E of 8 for
comparable firms reasonable?
Instead of using an earnings multiplier many merchant bankers
prefer to use a cash flow (or EBITDA or free cash flow) multiplier.
Again the multiplier is obtained from observing comparable firms.
Assume the cash flow (EBITDA) multiplier of comparable firms is 6
and the firm's cash flow (EBITDA) is $20,000,000. Now the firm's
estimated value is $120,000,000. If the debt is $40,000,000 this
value is consistent with the $80,000,000 value of the stockholders'
position obtained previously. The value normally obtained using
EBITDA is the firm's value (debt plus equity) rather than the stockholders'
value.
Now let us consider the average P/E of 8 for 10 comparable
firms. Assume that 9 firms have a P/E of 5 and one firm has a P/E
of 35.
The harmonic average takes an average of the reciprocals and
then takes the reciprocal of the average.
Is a P/E of 8 or 5.47 the correct average for purposes of computing
the firm's value?
The conventional average (the P/E of 8) tends to weight extreme
values higher than is appropriate. For example, assume there are 3
comparable firms, 2 with P/Es of 10 and 1 with a P/E of 100. The
conventional average P/E is 40.
It is not obvious that 40 is the correct measure. The example
could be more extreme by having the P/E of the third firm 10,000
(as might occur if earnings were unusually low for the observed
year). The average P/E is
The 14.99 P/E multiplier would seem to be more useful for valuation
purposes than the 3,340 P/E multiplier.
Multipliers: Theoretical Basis
The use of the average P/E of comparable firms has the complexities
of determining firms that are actually comparable and computing
the average P/E. An alternative approach is to compute a theoretical
target P/E based on the firm's economic characteristics. We will consider
three different multipliers, all of which will be used to compute
the value of the stock.
M0 applied to after-tax earnings: M0(E) M1 applied to earnings
before interest and taxes: M1(EBIT) M2 applied to earnings
before interest, taxes, depreciation, and amortization:
M2(EBITDA)
Determination of M0
Let P be the value now of a share of common stock. Then by definition
of M0:
P = M0E
Remember the above example assumes zero debt. With outstanding
debt the formulation becomes more complex.
The above multipliers cannot be applied to a different firm with
a different cost of equity and a different growth rate. The multipliers
were computed based on specific information, and other information
will lead to different multipliers.
Since all the above measures are based on objective measures of
earnings, EBIT and EBITDA, they appear to be objective, but in fact
all the calculations have a significant subjective input. However, the
appearance of objectivity makes them popular methods of valuation.
Since all the methods are implicitly assuming future benefits, it is
sensible to also compute the present value of these benefits.
MEASURES OF PRESENT VALUE __________
We consider six different present value calculations that are actually
all equivalent, thus are actually one method:
1. Present value of future dividends for perpetuity
2. Present value of discretionary (free) cash flows
3. Present value of future earnings minus the present value of new
investments
4. Present value of an earnings perpetuity plus the present value of
growth opportunities (PVGO)
5. Present value of dividends for n years plus present value of the
firm's value at time n
6. Present value of economic incomes
For the infinite life situation with the firm earning $65 and paying
$39 of dividends, a .12 cost of equity and a .02 growth rate, the
value is:
The firm is retaining .4 of earnings and has a growth rate of .02.
This implies that incremental investments earn .05. Since .05 is less
than the cost of equity, the undertaking of the growth opportunities
actually reduces value.
Instead of assuming one growth rate for perpetuity one could
assume a series of changing growth rates. The calculations and formulations
are more complex, but the logic is perfectly consistent
with the infinite life and one growth rate model.
FREE CASH FLOW _______________________
If free cash flow is defined to be equal to the cash flows as defined
(after all investments), then there are no complexities. The preceding
calculations apply.
If the free cash flow is after maintenance cap-ex, but is not equal
to the preceding cash flows, both sets of calculations would require
adjustment to reflect the additional investments.
CHANGING THE CAPITAL STRUCTURE_________
If the people valuing the firm intend to substitute debt for equity,
then the changes in capital structure can give rise to an increase in
value. This potential increase in value is discussed in Chapter 5.
EARNINGS VERSUS DIVIDENDS VERSUS CASH
FLOWS: PRESENT VALUE CALCULATIONS
Assume the objective is to compute the value of a firm using present
value calculations. Should earnings be used? Since earnings fail to
consider the funds necessary to be reinvested to generate future
earnings, earnings cannot be used without adjusting for reinvestment
or alternatively using the present value of economic incomes
illustrated previously in this chapter.
The risk-adjusted present value of future dividends is a theoretically
correct method of computing the value of a firm's stock
equity, if dividends are defined to include all cash flowing from
the firm to the stockholders, whatever the form of the flow. Despite
the correctness of using dividends, there are complexities.
First, the amount of dividends is a derived measure. It is derived
from the projections of future cash flows or earnings of the firm.
Second, in a situation where there are no cash dividends it is very
difficult (but not impossible) to estimate the future dividends.
Third, an acquirer tends to be more comfortable with the use of
the target firm's cash flows or earnings. Where the target firm is
paying a dividend, the difficult estimation problem is to determine
the growth rate for perpetuity. An alternative calculation is to estimate
the growth for n years and multiply the dividend at time n
by a multiplier to represent the firm's value at that time. Since the
target firm's dividend is likely to be changed (or eliminated) after
the restructuring, the dividend calculation is likely to be viewed as
misleading.
ESTIMATION PROBLEMS __________________
If the economic incomes as illustrated are used to compute value,
then the various accounting conventions do not affect the value
measure. It appears that the initial book value and the allocation
of costs to time periods affect the value calculation using earnings,
but the appearances are misleading. Among the accounting
conventions that do not affect the theoretical value calculation
adjustment are:
■ Depreciation method
■ Expensing or capitalizing of expenses (including R&D)
■ Write-off or not of goodwill
Income with a multiplier cannot be used easily if:
■ The firm has a loss or very small income compared to assets. ■
The firm has a large amount of noncash utilizing expenses
(goodwill and depreciation expense) compared to income. ■
The accounting income measure is not reliable. ■ There are
extra assets recorded or not recorded. ■ There are
unrecorded or recorded excess liabilities.
For any method where the future benefits are being discounted
to the present there are the problems of determining the discount
rate and estimating the growth rate.
If the firm is not investing any of the earnings, then dividends
equal the earnings and there is not likely to be large expected
growth. This simplifies the value calculation but also is likely to result
in a lower valuation, compared to a growth situation.
BUYING FOR LIQUIDATION _________________
In some situations a target firm is acquired so that it can be liquidated.
In 1988 American Brands Corporation acquired E-II Holdings,
Inc. for $1.1 billion plus the assumption of E-II's debt. It
acquired 18 different operating units plus 7.1 million shares of its
own stock (with a value of $320 million). American immediately
sold nine of the units for $950 million of cash (plus $250 million
of preferred stock that was worth very little), plus the E-II debt
was assumed by the buyer. In acquiring E-II an important consideration
for American Brands was how much it would be able to
obtain for the units to be sold. It also wanted to purchase its own
shares and repel a raid. American Brands was employing a Pac-
Man strategy. Since E-II acquired American shares, American acquired
E-II. E-II's probable intention was to liquidate American
(American consisted of tobacco, office products, liquor, and financial
services).
CONCLUSIONS__________________________
Valuation is very much an art. This is particularly true when the
firm does not have a long history of earnings and cash flows.
The difficult part of valuing a firm is to obtain reasonable estimates
of future cash flows or earnings, but it is important that once
these measures are obtained they be summarized correctly.
There are a variety of measures all with some highly subjective
element that can be used by the decision makers in attempting to determine
the value of a firm. There are exact methods of calculation,
but there are not exact reliable measures of value.
The going concern value of the assets, with the assets gaining
their value from the cash flow, is the relevant measure. The prime
advantage to be gained by using cash flow versus conventional income
is that it is theoretically correct and it does not tie us to the results
of accounting procedures that are not designed for this specific
type of decision. If the decision makers want to use the current income
as the basis for making their investment decision, care should
be taken, since the computation may not be equivalent to the use of
cash flows. However, even if they do not use the income measure directly,
the decision makers will use it indirectly as the basis for their
evaluation of future dividends.
Remember that in no case is the value determined by calculating
the present value of the accounting earnings. This calculation is not
theoretically correct. The present value of economic incomes can be
used, as long as the initial book value, ending book value, and terminal
value are all included in the calculation.
But even when the firm has a long history, there is always the
question of whether there has been a significant change in the business
environment; thus the firm's past history may not give a good
indication of the firm's future performance.
In many situations the verbal description of the reasons why
the firm has value is more relevant for valuation than a value derived
from growth rate assumptions that cannot be adequately
justified.
In conclusion, you should do calculations, but fully describe the
assumptions, the basis of the assumptions, and also estimate the
value of the firm if these assumptions are not valid.