Notesale: Turn your study into money

Document Preview

Extracts from the notes are below, to see the PDF you'll receive please use the links above

---

Joven Liew Jia Wen
MSIN3004 M&V Notes
Session 1: Orientation, overview of company and merger valuation

Clark Literature review on Company Valuation Methods from Time is Value
Models we use for valuation may be quantitative but inputs leave plenty of room for subjective
judgment
...

Three valuation methods




DDM (Dividend Discount Method)
DCF (Discounted Cash Flow)
Price-to-Earnings multiples (Multiples)

Gordon Formula (GF) is the prevailing method to estimate Terminal value (TV) in the 2nd stage
in Discounted Cash Flow method (DCF2S)
...

Primary difference between DDM and DCF is whether dividends appear in that ratio’s numerator
(DDM) or Free Cash Flows (FCF)
...

Gordon Formula Assuming Perpetuity (GFAP) represents today’s prevailing methodology for
estimating company terminal value (TV)
...

DCF version comprises of FCF, WACC, g
Further challenger to GFAP is an adaptation of GF itself which includes valuation life span (time,
t) as fourth variable with company-specific projections of t
...


P/E Price to Earnings Multiples











are often based on a single year’s forward estimate of reported earnings per share (EPS)
Technique is based on a fraction of the forecast information usually contained in the Explicit
Projection Period (EPP) analysis of stage 1 of DCF2S
...
A triple digit P/E seemed suitable for Lehman Bro’s pricing of Lastminute
...
6 weeks later when the Internet Bubble burst, Dot com valuations based on
Jan-Feb 2000 P/E appeared overvalued
...

But time or company longevity is actually a variable-determinant of company value

Two Stage Discounted Cash Flow Method (DCF2S)













Duration of initial stage is Explicit Projection Period (EPP)
Second stage: Terminal Value Period (TVP)
DCF2S Stage 2 Terminal Value is not calculated using operating budget-quality information
as in the case of Stage 1 EPP
TV is generated by the interaction of the assumption of the 3 broadly defined acknowledged
variables in GFAP
3 variables are: continuing period initial year annualized Free Cash Flow, cost of capital and
FCF future growth rate g
Because it is an estimation technique, TV is at times viewed as excessive
Overly optimistic TV calculations using Gordon Formula
Valuation academicians seems uncomfortable when TV exceeds 70% of CV
TV percentages vary from industry to industry and influenced by level and pattern of
investment, pricing flexibility, competition intensity etc
Literature on company valuation embraced DCF with the publication of Stern’s article that
Earnings don’t count
Damodaran states that perceptions of value has to be backed with reality and price that is
paid for any asset should reflect the cashflows it is expected to generate
Copeland et al suggests that DCF-based methods are closer aligned to market value (MV)
than accrual accounting-based methods

Joven Liew Jia Wen
MSIN3004 M&V Notes







Prevailing practice is estimating Terminal Value (TV) using DCF version of the 3 variable
Gordon Formula
Terminal Value (TV) often comprises more than half of a company’s total estimated value
(CV)
FCF annualized amount of the end of the EPP is often assumed to be identical to the FCF
annualized rate as of beginning of TVP thus becoming FCF variable of Gordon formula
Growing popularity of DCF methods and persuasiveness of Lundholm and O’Keefe against
accrual accounting valuation equivalence contention
Copeland et al regressed analyst-generated discounted cash flow estimates and have R2 of
94%
Near perfect correlation between the DCF/book value ratios for 31 large companies and
those companies’ market value to book value (MV/BV) ratio

Alternative TVP methodologies
















Assume alternative finite analysis of time span
Unlike the perpetuity assumption since eventual death of companies is an unavoidable
organic reality
For ex
...
7
years
Or look at company bespoke estimation: Finance director dictate appropriate valuation
analysis time horizon
Look at comparative advantage period (CAP) which relates to firm’s financial, operating
viability as indicated as CFROI
Mauboussin Johnson proposition is that the company’s timing as a viable entity ends when
Cash Flow Return on Investment (CFROI) rate no longer exceeds firm’s cost of capital rate
Company’s days are numbered if returns from investment do not exceed costs
But company may continue daily trading despite firm’s effective death
Ex
...
“Valuation Matters
...
AT&T one is 50%
Hence, businesses that face extreme uncertainty and substantial mispricing (companies
with high valuation quotient) need valuation expertise to create long term shareholder value
Potential impact of valuation activities = valuation quotient x estimated mispricing
percentage
This gives the potential gains and losses from valuation decisions
...
This is a dangerous game to play as no
guarantee there is such an investor around when the time to sell comes
...
Financial assets are
acquired for the cash flows expected on them
...
Price that is paid for any asset should
reflect the cash flows it is expected to generate
...
They
offer tremendous promise because of large member bases but still in early stages of
commercializing that promise
Information specific to firm, information that affect valuations of all firms in a sector and
information about state of economy

Myth 3: A good valuation provides a precise estimate of value




Unrealistic to expect absolute certainty in valuation due to the assumptions we make
Depending on where the firm is in life cycle, mature firms tend to be easier to value than
growth firms
...
of inputs needed increase and this increases
potential for input error
Need to adhere to principle of parsimony: do not use more inputs than you absolutely need
to value an asset
Recognise the tradeoffs between benefits of adding more detail and estimation cost
Models don’t value the companies, you do
...

Underlying assumptions: Relationship between value and underlying financial factors can be
measured, relationship is stable over time, deviations from the relationship are corrected in a
reasonable time period
Philosophy of Franchise Buyer like Warren Buffett is that we stick to business we believe we
understand
...

Franchise buyers are attracted to undervalued good business and how much additional value
they can create
...
They believe that
average investor in the market is driven more by emotion than by rational analysis
...
They are interested in the relationship between info and
changes in value rather than value per se
...

Efficient marketers believe that market price at any point in time represents the best estimate of
the true value of firm
...

Valuation in acquisition analysis






Bidding firm has to decide on a fair value for target firm before making a bid
Target firm need to determine a reasonable value for itself before deciding to accept the
offer
Effects of synergy on combined value of two firms
Effects on value of changing management and restructuring
But there are bias: Target firms may be overly optimistic in estimating value

Conclusion: Valuation is not an objective exercise and any preconceptions and bias an analyst
has will be in the value
...
The oil company will only develop the oil reserve only if oil prices go up and will not if oil
prices decline
Option pricing model would yield a value that incorporate that right

Clarks and Mills Chapter 6
Today’s social networking (SN) boom means emergence of 2nd top tier group of internet
segment leaders such as Facebook, LinkedIn and Twitter
With their own business models dependent on revenues from merger activity rather than merger
success, bankers are the ‘straw that stirs the drink’ when it comes to generating business and
merger expansion enthusiasm
...
Negotiating leverage is impaired as
acquiring CEO signaled that he is too eager
Share prices in target industries have risen due to regrettable war chest announcement
Significant correlation between increase in stock price and increased levels of merger
activity
Target company price goes up and acquirer’s goes down due to uneven distribution of
efficiency gains
3 types of acquisitions: Expansion-defensive (use inflated ‘currency’ to secure future areas
of growth), emerging consolidation (company cannot be leader so rush to consolidate),
bricks-to-SN (broadening product offering)
FB used its shares as acquisition currency to strengthen core
Twitter acquired Canadian startup Summify to facilitate management of massive amounts of
information continually entering activity streams
Zynga acquired OMGPOP Inc to expand company’s scale through mergers
For executive management in industry company stuck with low growth, being part of
something of universal appeal may prove to be irresistible
...
‘Valuation’ surged in unattributed reference to purported
‘knowledgeable source’ even though there is no material improvement in company’s
projected future internal CF generation
Continuing shareholders of acquiring company should be the ones to set criteria for
valuation measures

Joven Liew Jia Wen
MSIN3004 M&V Notes










Price ‘quotes’ by wafer thin pre-IPO trading services such as SharesPost should never be
confused with public market prices
A zealot investor might be willing to pay a lot for one share but it is not indicative of the
demand of other buyers who are temperate and more analytical
First wave of fanatical buyers are notorious for deliberating overpaying in order to be first to
own shares of prize company
By extrapolating that non-representative zealot price quote into the future, there are
foundations of fake (zealot silver price leads to new fantasy valuation)
Permanent investors ignore hyped IPO prices and seek to establish their own sense of
firm’s worth based on present fundamentals
FB IPO valuation was inflated to 75-103 billion which has no relationship to bid interest from
informed block shares bidder
Post-IPO price waterfall
Wait for the shakeout period to be completed and for the market sense of true valuation to
emerge
...

Discount rate too high  company risks rejecting valuable opportunities that its competitors will
happily snap up
Discount rate too low  company commits resources to projects that erode profitability and
destroy shareholder value
Standard formula for cost of equity is the capital asset pricing model (CAPM) where company’s
cost of capital is equal to the risk free rate of return (yield on 10year treasury bond) + premium
to reflect risk of investment in question
Beta reflects the volatility of the stock and the degree to which it has historically moved up or
down with the market
People have started to question the basic assumptions behind beta and if beta-based measures
are unreliable, valuation is unreliable
...
In mid 1990s, before the return of Steve Jobs, Apple was in a mess but it has a lower CoE
of 8% as compared to IBM’s CoE of 12% since its beta was half of IBM’s
...

Conflict between Volatility and Correlation






Beta is a measure of both correlation and volatility
Apple’s stock was twice as volatile as IBM but correlation with market movement was only ¼
of IBM
Therefore, Apple had a beta of 0
...
09
Adjusting for correlation can distort estimates of risk
For diversified investors, a stock with low correlation with the market is a diversifying hedge

Joven Liew Jia Wen
MSIN3004 M&V Notes


For corporate investors, they control risk by good management of operations and not
diversifying away

Reliance on historical data




Problem with beta is that it is calculated with data from some past period
Notoriously sensitive to small changes in the time period used
A company’s stock to market correlation is in constant flux

Indifference to holding period




A company typically calculates just one estimate of its discount rate and applies to all future
projects regardless of life/horizon
...
Expropriation
Corporate default risk: additional risk that company will default due to mismanagement
Equity returns risk: extra risk equity investor bears due to his residual claim on company’s
earnings secondary to debt holders
Compensation for national confiscation risk: govt bond rate for given time period
Compensation for corporate default risk: premium above govt bond rate that corporations
pay to obtain funds
Determine degree of volatility using Black-Scholes pricing model
Easier to calculate MCPM for large companies like GE which have many options and futures
traded on their stocks
For smaller companies, we use options written on comparable companies or extrapolate
from shorter dated options
MCPM rate for Apple in 1998 is 19
...

 Valuation of the IPO just become higher and higher despite no inherent improvement in
fundamentals
...
It is a selling document and not an analysis article
...
Dealing with fictional
strategy
...

 Growth margins and profitability are flawed
...
Demographic situation is adverse
...

 Stagnant economy with no buying power hence not possible for loss-making operations to
suddenly become profitable
 Even in US, it takes two years to reach profitability so estimates in this report are unreliable
...
EPP is usually 4 years
...
Dual exaggeration
...
FCF carried forward
error
...
g in JT is used at a fixed rate of 6% but this is a gross exaggeration that
leads to infinite TV
...
2% sloping to 0
...
The Beta of JT is 0
...
The actual
beta should be 1
...
There has been miscalculation in the correlation since beta includes
both correlation and volatility
...

Should have used 10 year gilts of UK or 10 year US treasury bonds
...

 Furthermore, peer companies selected for comparison are some Eastern European
companies
...

 Being a Telecom company, you would assume it requires heavy investment so it is not
accurate that investment would suddenly go to zero to let FCF increase artificially for a year
 EPP should have been zero and a bottom up approach is required to come up with credible
numbers
...
The high amount of debt may
increase WACC
...
6%) and have a robust ROE of 12
...
8 to 979
...
5% the stripped yield of 10year Jordanian
Brady Bond and a company beta of 0
...
96 is suspicious; the real beta should be 3 instead since the company is
selling phone plans to people who cannot afford it
...

The risk premium used is the brokers equity risk premium for CEEMEA markets of 6%
Resulting in JT having a WACC of 13% since it is financed with 20% debt and 80% equity
...

JT has a monopoly in providing fixed line voice services until 2004
...

JT’s Return on Assets (ROA) decreased slightly due to decrease in operating profit margin as a
result of tariff rebalancing in anticipation of increased competition
...

JT’s current ratio fell but ratio of long term debt (gearing ratio) fell too so financial risk to future
owners is reduced
...
BUT it has a rather low revenue per employee
...

Risks: Telecommunication sector in Jordan is subjected to heavy regulation, liberalization of
fixed line telephone service industry that influences forecasted revenues, end of mobile
telecommunications duopoly that reduces profitability, regional political and economic risk, rapid
changes in technology

Lecture 1
EXAM QNS: Peter Clark Lit review on the 3 Valuation methods, DCF2S
Worth of the company = Future cash flows + what company is worth now
Near perfect correlation between CF and share price so CF comes first
Use Discounted Cash Flow 2 Stage (DCF2S) to calculate Jordan Telecom’s valuation
DCF2S involves Explicit Projection Period (EPP) and Terminal Value Period (TVP)
...
Able to calculate the CF from the operating budget for EPP
After 4 years, cannot do full line projection therefore use Gordon’s Formula or William’s Formula
...
PayPal should break away from Ebay
...

Earnings per share (EPS): Company’s reported net income/shares outstanding
Net Operating Profit after tax (NOPAT): Reported Net Income but excluding any non-continuing
sources or extraordinary income
Depreciation: Principal non-cash category that refers to the period charge against obsolescence
of physical or other tangible assets
...
Share buybacks and dividends do not create value
...

of shares outstanding but EPS increases, creating a psychological effect
...

Valuation is the estimation of something’s worth and an entity is worth the cash flow it generates
...
It is impossible to add value to all stakeholders
...
Same with
Ford Motor acquiring/disposing Volvo and Saab
...
Foundations are fake
...
This is consistent with the paramount financial
purpose of a corporation which is to maximize shareholder value in the long term
...
Amazon
manages by cash flow
...
CEO Apotheker
destroyed value through strategic missteps at HP and was sacked within a year
...

Create external expansion (merger) currency (Share price increases when you manage by
cash flow and marginal cost of equity falls
...
Quality
analysts ignore company propaganda on ‘vision’ etc
...

Company’s management that does not attend to CF development is suspected of attempting
to divert the financial community’s attention away from underperformance
...
92 (near perfect
correlation) as examined by Copeland et al and Kaplan and Ruback
Philosophies of Asset Pricing





Fiat value (worth is set by government authority and subjected to market demand)
Intrinsic value (usually for precious metals like gold that reflects the presumed inherent
characteristics of the asset but then again, gold price changed dramatically too)
Utility value (Based on performance, profits generated such as uranium and machinery but
usefulness changes)
Market value (stock price that reflects assessment of numerous independent buyers but
subjected to fiascos and bubbles)

In theory, external financial market’s assessment of a given company’s worth as reflected by
firm’s share price is identical to the future expectations of the company’s FCF operating
performance
...

Crisis and bubbles occur
...
The
Post IPO share price collapsed (IPO waterfall) and is coined as a 99 percenter since share price
(worth) collapsed
...

THE GOOD, THE BAD, THE UGLY
 THE UGLY: Multiples (P/E) that are dominant among bankers and pop-biz but fatally flawed
and lacks credibility in corporate valuation community
...

 THE BAD: Dividend based methods such as Dividend Discount Method (DDM) or Dividend
Value Method (DVM) are accrual accounting
...


Joven Liew Jia Wen
MSIN3004 M&V Notes
 THE GOOD: Two Stage Discounted Cash Flow (DCF2S) which is the dominant method now
and embraced by academia and CFOs
Multiples is accrual accounting based, retrospective and reactive and extrapolated from past
numbers
...

There has been limited good scholarly literature on multiples
...

DDM was prevailing method in 1950s due to Gordon Shapiro and Lintner
...

However, dividends come from accrued earnings and original dividend payout design may not
equate dividends to FCF
...

Dividends are also subjected to management manipulation
...
Extraordinary dividends are used to placate activist
shareholders and create short term positive news
...

EXAM QNS: Feltham Ohlsson Clean Surplus non logic just maintained that by definition,
accrual accounting based income (dividends) = share price
DDM supporters failed to refute the substance of the near perfect correlation of CF and share
price
...
During the Explicit Projection Period (EPP),
company can have very near term FCF projections with high degree of certainty based on prior
estimation accuracy and operating budget
...
WACC depends on CAPM analysis
...

WACC = cost of equity x proportion of equity + cost of debt x proportion of debt
Both cost of equity and debt involve risk free rate
Beta = 1
...


Session 2: Company Valuation Methodological Issues I

Damodaran Chapter 13-14
Dividend discount model (DDM): value of a stock is the present value of expected dividends on
it
We use the Gordon’s growth model in DDM to value a firm in steady state and dividends are
growing at a rate that can be sustained forever
...


Joven Liew Jia Wen
MSIN3004 M&V Notes
Model is extremely sensitive to assumptions about growth rate
...

Payout ratio = g/ROE
Two-Stage Dividend Discount Model is based on two stages of growth – an initial phase where
growth rate is not a stable growth rate and a subsequent steady state where growth rate is
stable and expected to remain so for the long run
Limitation of 2S DDM: Difficult to define length of extraordinary growth and it is impossible that
growth rate is high in initial period and transformed overnight to a lower stable rate at the end of
the period
H Model for Valuing Growth: two stage model for growth where the growth rate in initial growth
phase is not constant but declines linearly over time to reach the stable growth rate in steady
state
Limitations: the decline in growth rate is expected to follow the strict structure and large
deviations can cause problems
DDM is simple and its intuitive logic is easy to understand
...
of stable, high-dividend-paying stocks
...

Dividend payout ratio: dividends/earnings






Most firms usually pay out less to stockholders so that there is available free cash flows in
the company
...
They do not increase dividends haphazardly as it is uncertain about their capacity
to maintain it and it is difficult to cut dividends in bad times
...

Firms often use dividends as signal of future prospects and use of dividends as signal lead
to differences between dividends and FCF
Managerial self-interest to retain cash rather than paying out as dividend

Stern 1974 Earnings per Share Don’t Count
EPS is often a misleading indicator that can result in costly decisions that shortchange common
shareholders and severely misallocate company’s resources
...

Share price are not determined so simply so relying on EPS to evaluate alternative acquisitions
candidates result in costly decisions
...

EPS can be enhanced by simply employing debt and a bad investment often can be made to
look good by leveraging the firm sufficiently to increase EPS
...

Investment decisions should be made independently of financing decisions
...
of shares outstanding
Mechanical reliance on EPS encourages expansion of debt to cover dubious projects
...

EPS criterion dictates that high PE firms should issue shares to retire debt however debt-free
policy is hardly beneficial to shareholders
...

Key determinant of market price = expected rate of return on incremental capital invested
...
In an
efficient market, a company’s current share price is based on info available today about a firm’s
expected risk and future profitability
...

FCF is most important
...

CAP is different from company’s own strategic planning forecast period
...
The higher the ROIC, the better the
company is positioned within the industry
...
Terminal value is when
CAP intersects the time axis
...
Companies with high
multiples tend to have longer CAPs
...

Market Implied CAP (MICAP) is derived from current stock price
...

Warren Buffet buys businesses with high returns on capital excess of cost of capital that have
sustainable CAP
...


Joven Liew Jia Wen
MSIN3004 M&V Notes
Microsoft created roughly $100billion shareholder value in a decade due to dramatic
lengthening of company’s implied CAP
...


Clark 1991 Chpt 3: The Value and Cash Flow Linkage
Acquisition valuation, like merger success, lends itself to the specific interpretation by the buyer
and the seller based on their objectives and transaction dynamics
...
However, sellers rarely part with their
investments except at prices perceived as being greater than current worth
...

Value difference, on the other hand, assumes that price bid and justified market value of
acquired company always differ and the bid is always greater
...

Price and value are not necessarily the same thing
...

Acquisition purchase premium in the market can be 30 to 50%
Adjusted market value = Market value is adjusted upwards by any additional benefits acquirer
assumes that are not reflected in current stock price and downward as necessary to adjust for
unrecoverable cost that cannot be offset through future operations
Control and consolidation cost are the additional cost acquirer has to pay to control enough
shares to force an acquisition esp if present shareholders don’t want to give up their shares
...

*According to Time Value of Money, a dollar received today is worth more than the same dollar
received in the future
...

Company’s internal rate of return (ROR) can be improved by dropping bottom programs with
lowest IRR
...

EPP: finite period in which growth is assumed to be explicitly captured in the projected cash
flows over that period
TVP: period beyond EPP where a certain level of net cash flow is assumed in perpetuity that
grows at an assumed rate g
Market Implied Competitive Advantage Period (MICAP)
In the case of Jordan Telecom, a 1% change in g alters the estimate of fair market value by
10%
...
With such a large
proportion of total value affected by assumed growth rates, it is critical to understand their
validity
...
More geographically
proximate Gulf operators are more advanced
...

The estimates for perpetuity growth in the case of Jordan Telecom were overoptimistic
...
Originally stated IPO price was overstated
...
There is also the challenge of finding comparable
companies in the first place
...


Lecture 2
EXAM QNS: Discuss Liu scholarly article on multiples
Liu’s paper on multiples is a bad literature paper that does not prove that multiples is a good
valuation technique
...
It is not a proof
...
However, if there is a 4th variable in Gordon’s formula, it is
time where time is not infinite
...

DVM is the same as DDM
Mills mentioned that the Jordan Telecom’s growth rate of 6% is ridiculous
...

Worth of the firm is determined by DCF2S and not share price
...
94 R2 for correlation with share price
...
MSV
done correctly is maximizing DCF on a continuing basis
...
For Jordan Telecom, beta should be
3
...

EXAM QNS: Company valuation
EXAM QNS: Stern was right
...
94
Jordan Telecom’s g = 6% is ridiculous
...

Stern’s paper = Earnings per share don’t count and can easily manipulate EPS
...
Company won’t exist forever so TVP is not forever
...
4 years and company value is generated by changes in FCF
...

Near perfect correlation between CF and share price


Not a coincidence since same result obtained with larger sample

Joven Liew Jia Wen
MSIN3004 M&V Notes




Has to be causal because statistically proven and supported with anecdotal observation
(new major profitable project that increases CF leads to increase in company share price)
Not share price governing because rational market assumption does not hold and share
price is subjected to panics and manias (Ex
...
CF governs share price
...
However, ROE increases when gearing increases
...
The past is not a good
indication of the future
...
HP and IBM were flourishing in the past but on a
decline now
...

Apple was different under Steve Jobs
...

Effective Value Management = Manage the elements of value creation in a manner consistent
with maximizing shareholder value based on DCF
Armstrong at AT&T or AOL is dismissed for not fully developing and implementing these value
levers
...

Effective valuation requires measuring forward performance in a defensible manner: DCF2S
Total Company Value (TCV) = Present value (PV) + Future value (FV)
***Value levers
 Assets = asset value composition refers to the amount and percentage of value creating
assets where value creating means returns higher than WACC
 Return on Assets (ROR) = return on active assets is the return on company’s assets after
value based adjustments
 Weighted average cost of capital (WACC)
If CFROI > WACC, company is making money
...

Change the software development and support philosophy: Microsoft should shift from a
closed model to selected multiple platforms
...

Money left on the table for years
Orderly sale of Xbox: Xbox is a great product but a distraction for a company that needs to
get focused fast
Cull marginal product and operations including Bing: any product/division that cannot be
core activity should be positioned for exit
...

Introduce a much simpler organizational structure: 7 layers of management is the maximum
Introduce and enforce a new culture and dialogue with key accounts: Established
companies need customers and not customers need them
Phase out Nokia: Nokia is a bad venture
New leadership at the top: Gerstner is a good CEO, first to discuss with Apple Chief Tim
Cook about Office for iPad

DCF2S
 Stage 1 is Explicit Projection Period (EPP) that reflects the PV of company’s CF which
management can credibly project over the near term
 EPP is usually 4 years due to the 2 year time span of company’s forward operating budget
 CF projection is built up from multi-line projection models
 FCF annualized running rate estimate as of end of EPP is used for next period TVP
 Stage 2 is Terminal Value Period (TVP) which uses the Gordon’s Formula
 Variables in Gordon formula are FCF, WACC, g
Stage 2 Dual Dilemma





Dilemma 1: g (Jordan Telecom 6% g appears to be ridiculous as g should decline over time)
Common sense ceilings of Peter Clark at Frito-Lay on Terminal value to be about 60 to 70%
of Total Company Value
Should have detailed variable projections of g over full Stage 2 analysis period
Instead of treating g as a single static variable, create rates of change reflecting changes in
competitiveness, aging product life cycles etc

Joven Liew Jia Wen
MSIN3004 M&V Notes






Dilemma 2: Perpetuity error (By assuming that Stage 2 duration never ends, Gordon’s
Formula may amplify any errors in g)
By taking time as infinite, you get a simple 3 variable Gordon Formula
Time should not be infinite and according to Reversion to Mean (RTM), high performance
companies tend to recede towards the mean at some point in the future
...
There is no way to do valuation without projection
...
There is minimal mention of multiples in literature
...
Dividends may not
be stable as seen from Tesco and BP cutting or removing their dividends payout
...
DDM has declining
mention in literature but still a primary valuation technique for industries with highly predictable
payout pattern
...
94 correlation between CF and share price
...
DCF2S is prominently showed in academic literature and more use of it in real world
too
...

3 variables: FCF, WACC, g
4th variable is time (perpetuity or finite)
There are issues with FCF, WACC, g
EXAM QNS: What is the problem with comparables?
Multiples are easy to understand however it is based on historical performance and just a back
up
...
Ex
...
Difficult to
find comparables and in fact for LinkedIn IPO, the wrong comparable of a small German firm is
used
...


Joven Liew Jia Wen
MSIN3004 M&V Notes
EPP for Jordan Telecom is too long
...
99% club
didn’t last forever
...

Boots got into trouble with pricing and Tesla is a controversial company
...

With Mavericks free, Apple loses a recurring source of income and Apple’s profits and
cash flows will fall
...

However, with the OS X free, customers no longer have to pay ongoing upgrade fees and they
feel that they are getting more by paying the same for buying Apple’s products
...

If Apple can get all customers on the latest software, the company gets more consumer
loyalty
...
Apple is a company that makes money off
hardware devices and online services rather than its operating systems so by making OS
X free, it can hopefully boost the waning traditional PC sales
...
1 free as an update and Google Chrome OS
which updates continually
...

Think Incremental DCF effect vs opportunity cost (value relating to next best alternative)
EXAM QNS: What is the point of the Mavericks case?
By giving Mavericks free, Apple is doing a value creating action and not value destroying act
...









Mavericks is free, resulting in Apple losing a recurring source of income
However, this is only a small part of Apple’s income since most of Apple’s revenue come
from hardware sales
By making Mavericks free, Apple made a first mover advantage and received headline
coverage worldwide, gaining free billions of dollars worth of advertising
It created a splash and Apple’s share price rose by 15%
Apple also removed the administrative group that handles the updates and every Apple user
get the software free
It changes the people’s mentality as well since they know they can invest in Apple hardware
and get future updates free
Apple knows that Microsoft cannot do this
...
By making Mavericks free, Apple is dealing a great blow to
Microsoft and Microsoft is forced to follow suit and make Windows 10 free

Joven Liew Jia Wen
MSIN3004 M&V Notes



Apple is playing its advantage in hardware and encouraging people to purchase Apple
hardware and be part of Apple tech ecosystem
By incremental DCF analysis, Mavericks free is a value creating act

Session 3: Company Valuation Methodological Issues II

Clark (2010B) excerpt from Ch
...
By disregarding the company longevity’s role as a variable affecting
value in all enterprises, Gordon Formula Assumed Perpetuity (GFAP) may be calculated with
only 3 variables
...
company value
estimations based on dividends declaration of company management, as described in Gordon
and Shapiro 1956 paper
...
The second stage is typically referred to as the Terminal Value Period (TVP),
continuing period, continuous period or horizon period
...

Concept and components of GF were first described by Williams then Gordon and Shapiro then
Gordon himself
...
Time is the 4th variable if you don’t assume this
...

If t is infinite, variations in lifespans are effectively disregarded as influences on company value
...

Perpetuity conjecture also exaggerates errors in the FCF, WACC, g
...
Mauboussin expressed concern over the implausible near
vertical g function that arises when a positive rate is extrapolated to infinity
...


Joven Liew Jia Wen
MSIN3004 M&V Notes
In the case of high TV-to-CV percentages, concern might arise that most of company’s
estimated worth correspond to the continuing period and it is an approx
...


Companies do not endure forever and there are many factors that shorten a company’s lifespan
prematurely
...
Circuit City’s failure to confront its market and cost problems
Palm’s fatal delays in developing a competitive smartphone to compete with Apple’s iPhone
The perpetuity conjecture is wrong due to
 An extreme, impossible lifespan duration which NO company ever reaches (infinity)
 The one-duration-applies-to-all-firms inflexibility of this constant rule
***Prefer a valuation period with a finite-horizon forecast

Mitra: Note on CF Valuation methods (Comparison of WACC, FTE, CCF, APV
methods)
FTE = Flow to Equity
CCF = Capital Cash Flow
APV = Adjusted Present Value
Valuation of a firm hinges on measurement of 2 basic parameters
 Assessment of future cash flows
 Discount rate that reflects risk involved in the CF estimate
Discounted cash flow analysis is carried out on incremental cash flows related to the project
...

As time passes, it becomes increasingly difficult for a firm to maintain high growth
...

FCF is the sum of cash flows to all stakeholders of the firm, including both equity and debt
holders
...

To estimate cost of equity, we use the Capital Asset Pricing Model (CAPM) where expected rate
of return of a security is risk free rate + security’s beta multiplied by market risk premium
Risk free rate = return from government default-free bonds (To value a firm or long term project,
use return from long term treasury bill)
Average market risk premium is 5%
Required rate of return on equity also depends on financial leverage of the firm
...
Risks of project cannot be captured by a single discount rate
...
of years
Debt levels reduce year after year and capital structure changes year after year so APV is
most suitable

All methods discussed differ in approach but yield identical results
...
However, when capital structure changes over time, WACC
changes
For CCF method, only cash flow needs adjustment for changes in tax structure
...
However, it is noted that cost of equity changes when capital structure changes
...
FTE and
CCF are variations of WACC methods
...
Changes in tax and capital structure can be easily incorporated in APV
without altering discount rate of project
...
This invokes Law
of One Price
...

Market multiples are generally drawn from either stock prices for public companies (trading
multiples) or prices from completed transactions involving public or private companies
(transaction multiples)
...
Choice of Last in First out (LIFO) or First in First out (FIFO) accounting for inventory
affects cost of goods sold so adjustments are needed to obtain reliable multiples
Non-recurring items and non-operating assets (excess cash) differ across companies and
should be eliminated
Companies do not all have the same fiscal year-ends
Ensure a consistent backward looking (trailing) or forward looking multiple calculated for all
companies
Mean and median are the most common measures of central tendency but mean treats
outliers differently from median
...
Minority interest in private company that may not be sold during a stipulated period then
need to adjust for illiquidity
Size difficult to estimate, depending on source, degree and duration

Practical issues/Problems








Small samples of comparable companies lead to less reliable summary statistics
Sometimes, multiples are inferred not from the mean, median but upper/lower quartile
Multiples based on transaction data are culled from deals that occurred at different points in
the past (Historical data can lead to misleading multiples)
Historical data not a true reflection of the current or future situation
Transaction multiples can be distorted by seasonality or cyclicality
Equity multiples are sensitive to leverage
There may be unreliable market data and prices may be affected by noneconomic
phenomena

Conclusion: Market multiples are over-simplistic and non-rigorous
...


Joven Liew Jia Wen
MSIN3004 M&V Notes

Kellaway FT: Finnish Lessons for Goldman Sachs
Goldman produced a 63 page document on how it proposes to clean up its act which began
with the 14 Goldman Sachs Business Principles
...

First principle of Goldman: Our clients always come first
...

Finnish retailer Stockmann has 4 more principles: efficiency, commitment, respect for its staff
and social responsibility (our way of operating is ethical and just)
By contrast, Goldman makes a meal of being ethical
...

Goldman principles aren’t internally consistent and there is a conflict between making money
and serving clients
...
BUT
Goldman’s list of principles is of no help to decision making since it is a mixture of untruths,
platitudes and boasts
...


Damodaran Chapter 12 and 15: Estimating TV, Cost of Capital and APV
Estimating Terminal value has 2 approaches
 Going concern approach (firm continues to deliver cash flows in perpetuity)
 Liquidation approach (firm has finite life and assets are sold at end of that life)
As a firm grows, it becomes more difficult to maintain high growth and it eventually grows at a
rate less than or equal to the growth rate of the economy it operates
...

Liquidation value is the estimate that emerges when a firm ceases operations at a point in the
future and sells the assets it has accumulated to the highest bidders



Based on book value of assets and adjusted for inflation during the period
Based on earning power of assets (discounted expected cash flow from assets)

If you are valuing equity, FCF to equity and cost of equity is used
...

Most difficult to estimate stable growth rate

Joven Liew Jia Wen
MSIN3004 M&V Notes







Small changes in g can change TV greatly and effect gets larger when g approaches
discount rate used
If stable growth rate is constant forever, there is strong constraint on how high it can be
since no firm can grow forever at a rate higher than the economy
Constant g cannot be larger than overall growth rate of economy
Whether the company is domestic or multinational will affect the g used (whether domestic
economy g or global economy g)
Whether g is in nominal or real terms
Currency used to estimate CF (high inflation currency means stable g is higher)

High growth period (before stable period) of firm






A firm experiencing high growth period means CFROI > WACC
Smaller firms tend to earn excess returns because greater room to grow and larger potential
market
Need to see potential growth of total market
Existing growth rate and excess returns matter: higher CFROI now means likely to have
high CFROI in near future
Magnitude and sustainability of competitive advantages: barriers to entry to maintain high
growth, brand names, patents

3 models for Transition to Stable growth
 2 stage model: high growth rate in one period and stable growth firm abruptly
 3 stage model: high growth rate in one period, transition period, stable growth period
 N-stage model: Firm’s characteristics change each year from initial period to stable growth
period
A firm may not survive forever as it may run into serious cash flow problems
...
A firm with expected revenue of $6bn and value-to-sales multiple of 2 then estimated TV of
$12bn
Multiples approach is simple but where it is obtained is critical
...
(relative valuation)
FCFF (Free cash flow to firm) = sum of cash flows to all claim holders including common
stockholders, bondholders, preferred stock holders
FCFF = FCFE + Interest expense (1-t) + Principal repayments – New debt issues + Preferred
dividends
FCFF = EBIT (1-t) + Depreciation – Capital expenditure – Change in working capital
FCFF is often called unlevered cash flows since it is prior to debt payments

Joven Liew Jia Wen
MSIN3004 M&V Notes
Discount FCFF with cost of capital = value of operating assets of firm
...

Using the Gordon formula, the stable growth model, the g has to be less than or equal to
growth rate of economy and the characteristics of the firm have to be consistent with
assumptions of stable growth (beta close to 1, stable firms use more debt etc)
Firms with very high/low leverage are best valued with FCFF approach since FCFE is more
difficult because of the volatility induced by debt repayment that affect value of equity
...
FCFF focus on predebt cash flows that blind us to
real problems of survival
...

APV valuation
 Estimate value of firm with no leverage (value of unlevered firm): Discount FCFF with
unlevered cost of equity
 Consider PV of interest tax savings
 Evaluate expected cost of bankruptcy
 Advantage: separate effects of debt into different components and analyst can use different
discount rates for each component
 Never assume that debt ratio stays unchanged forever
 Difficulty in estimating probability of default and cost of bankruptcy
 Alternative approach to firm valuation that can be used to estimate optimal debt ratio for firm
In conclusion, cost of capital approach is still a more practical choice when valuing ongoing
firms that are not going through contortions on financial leverage
...

Cost of equity depends on CAPM where cost of equity = risk free rate + beta (market risk
premium)
If default risk is too high like downgrade of bond rating can trigger significant loss in revenue
and increase in expenses

Lecture 3
EXAM QNS: How can we have 2 contrasting views that bankers predict surge in M&A activity
and Sarah said that if bankers think from client’s perspective they should close down M&A
department?

Joven Liew Jia Wen
MSIN3004 M&V Notes
Different definition of merger success: Bankers have a vested interest in it and merger success
to bankers is identified as closing the deal
...
However, looking at
discounted cash flow analysis, most M&A activities fail
...

Competitive advantage period is the period where CFROI > WACC
...
However, stock prices can be pumped up a lot due to overenthusiasm of the
market
...
We look at
operations and cash flow
...
Problems with FCF is that there
can be calculation errors with NOPAT and investment
...
Hence, if EPP is too long
(JT’s EPP of 7 years was too long) then FCF is wrongly estimated
...
Ridiculously high g of 6% can lead to compounding error and
very high TV
...
5% or lower and it can decline over the years
...
Gordon formula is used with the
numerator being the forecasted dividends
...
As long as there is consistency in
dividend payout, we can value a company
...
FCF runs the world
...
94 correlation between CF and share price
...
They couldn’t prove otherwise
...
CV is the sum of EPP + TV
...
At the same time, if g is estimated to be too high,
TV/CV ratio can be too high
...

Breakup is like a reverse merger
...

Breakup can be costly as companies lose cross subsidizing, need new HR department, less
efficient capital structure
...
If the reason to split off is to
deconglomerate and avoid conglomerate discount, there aren’t many conglomerates in the
West now
...

EXAM QNS: Rise and Fall of MFV/VBM
Maximising shareholder value is important
...
Some firms are mis-steered by value sounding concepts
...

EP reflects an understanding of the CF returns on the company’s base assets as the primary
value generating engine of firms
...

EP = NOPAT – Capital Charge
Capital Charge = WACC x Capital Employed
EP = ( NOPAT/Capital – WACC) x Capital
4 Fundamental strategies to create value
 Performance (improve the return on existing invested capital)
 Capital Structure (increase debt and reduce cost of capital if firm is still able to take on more
debt)
 Optimal capital structure traditional theory: using more debt raises risk of financial distress
but tax shield lowers cost of capital up to the point where too much debt makes it risky
 Growth (invest as long as CFROI > WACC)
 Asset management (Divest capital and remove value destroying assets that cannot give
returns higher than cost of capital)
However, it is difficult to use accrual accounting based measure to estimate capital charge and
economic profit
...

3 similar but different MICAP related measures of company’s worth
 MC = Market capitalization (shares outstanding x share price)
...
Sometimes, share prices are
affected by bubbles and fads
...

 MVE = Market Value of Equity = MC – Market Value of debt (MVD)
 MVE is a correct adjustment for debt as a claim which reduces equity and it is applied to
balance sheet debt
...
Also use the balance sheet debt
...


Joven Liew Jia Wen
MSIN3004 M&V Notes
WACC = sum of Cost of Equity and Cost of debt
Cost of debt = risk free rate + CB to lending institution cost + debt issuer’s service cost + profit
margin
Cost of equity = risk free rate + beta (market risk premium)
Equity risk premium is the additional to reflect risk to financing provider associated with a
diversified portfolio of common stock
McNulty paper on beta states that beta reflects both correlation and volatility
JT’s beta should be 1
...

Common element between cost of equity and cost of debt is risk free rate
...


Selecting a beta








Have strategy, activities or capital structure changed?
What time horizon is the most appropriate?
History a good indicator of future risk?
How reliable is the information and other statistics?
Any asymmetry in trading activity?
Special events like market crash?
Future change in capital structure expected?

Session 4: Applied Company Valuation, Value Management (VM)

Damodaran Chapt 17: Relative Valuation
Relative valuation






Objective = value assets based on how similar assets are currently priced in the market
Multiples are easy to use and intuitive, they can be misused
...

Multiples reflect market mood also implies that using relative valuation to estimate value of
an asset can result in values too high when market is overvaluing comparable firms and too
low when market is undervaluing comparable firms
Scope for bias

Enterprise value = value of operating assets of the firm = sum of values of equity and debt, net
of cash
Earnings multiples = multiple of the earnings that asset generates
Ex
...
Price-book value (PBV) or Enterprise value relative to book value of all invested capital
Revenue multiples can be price-sales (PS) ratio where market value of equity is divided by
revenues
Or Value-Sales (VS) ratio, where numerator is enterprise value of firm
Revenue multiples are easier to use to compare firms in different markets with different
accounting systems than it is to use earnings/book value multiples
...
Dot-com firms had negative
earnings and negligible revenues and book value
...
of hits
generated by that firm’s website
...

However, sector-specific multiples can be dangerous because they cannot be computed for
other sectors and there is no sense of what is high, low or average on this measure
...
How does a visitor to the website translate to revenues and
profits?
4 basic steps to using multiples
 Ensure multiple is defined consistently and measured uniformly across the firms being
compared
 Aware of the cross-sectional distribution of the multiple across firms and across entire
market
 Analyse the multiple and know what fundamentals determine the multiple
 Find the right firms to use for comparison and control for differences
Need to ensure that everyone is using the same definition for the multiple
...
Ex
...
The earnings per share can be from most recent financial
year or expected earnings per share in the next financial year (forward PE)
...
Likewise with firm value
Equity value = Market price, value of equity, earnings per share, net income
Firm value = Enterprise value, operating income, EBITDA, book value of capital
Different firms have different fiscal year ends, leading to great differences in earnings in high
growth sectors esp
...

Need to be aware of outliers, averages, bias in analysis
Value of equity = Expected dividend in next year/ (cost of equity – g)
A comparable firm is one with cash flows, growth potential and risk similar to the firm being
valued
...

Difficulty: How to narrowly define a comparable firm to get more reliable estimates
To control for differences across firm, we can have subjective adjustments, modified multiples or
market regressions
...
Forward earnings per share can be much higher/lower than trailing earnings
per share which can be different from current earnings per share
 Management options: Since high growth firms have far more employee options outstanding,
differences between diluted and primary earnings per share tend to be large
PE ratio increases when ROE increases
...

PE increases as growth rate increases assuming ROE> cost of equity
...
PE decreases when beta increases
...
Hence, would be cautious to compare with historical average of PE
...
This group is designed to give an upward bias
...

Dependency of PE ratios on current earnings makes them particularly vulnerable to year to year
swings
...

PEG ratio = PE ratio/ expected growth rate (in earnings per share)

Joven Liew Jia Wen
MSIN3004 M&V Notes
PEG ratio is used to identify undervalued or overvalued stocks
...

Firms with well known brand names sell for higher multiples
...
of customers, subscribers or website visitors
...
Multiples based analysis does not depend on credible estimates
of future synergies from the deal
...
Sales statistics can be distorted
...
It relies on accrual
accounting earnings information and not cash flow
...

Multiples depend on the believability of the comparables used and no two companies are
identical
...

Companies can differ in terms of business models, capital structure, market objectives, CAP
and different points in respective economic life span
...
Company’s earnings are unknown
...

To exploit multiples’ advantages, we have to make sure comparison between companies
occurs at roughly the same time during the economic cycle
...
Limit multiples
comparison to analysis over an extended period of time
...

For majority of companies, a combination approach reflecting separate businesses of the
corporation is necessary
...
It is
hence unclear which segment is the company comparable
...
ODCAP
...


Esty 1997 HBS Note on Value Drivers
3 Value Drivers
 Profitability
 Advantage Horizon
 Reinvestment
Discounted cash flow analysis translates future cash flows into current market values
...

Profitability







For a given industry, more profitable firms which are those able to generate higher returns
per dollar of equity should have higher market-to-book ratios
...
of years
Period during which firms generate positive abnormal returns = advantage horizon
The longer the advantage horizon, the higher the market/book ratio
Presence of positive abnormal returns encourages entry by new firms and increased
competition by existing firms
Over time, competition reduces excess returns to the point where firm only earns normal
rate of return
Therefore, firms should try to extend advantage horizon as long as possible for a given level
of profitability

Joven Liew Jia Wen
MSIN3004 M&V Notes






Ability to preserve comparative advantage (key determinant of value creation) =
sustainability
Firm needs to be able to create scarcity value and threats to this are imitation and
substitution
Firm needs barriers to entry or forestalling entry through aggressive positioning
Slack occurs when firms fail to create as much value as they are capable of creating
Advantage horizon is finite but companies like Coca Cola, Wal-Mart and Microsoft have
been able to extend their advantage horizons for many years
...
and most profitable investment opportunities should have highest
market-to-book ratios
...

Accounting data is subjected to manipulation by managers
...


Chadda et al: All P/Es are not created equal
A high multiple enhances a company’s strategic freedom
...

Coca Cola has a strong P/E of 24 despite low growth rate due to high 45% return on capital
relative to 9% WACC
...
Some high P/E companies may
just be high-returning mature businesses with few growth prospects
...

Consumer goods manufacturer would enjoy a large return premium, consistent with its high
historical returns on capital

Joven Liew Jia Wen
MSIN3004 M&V Notes
 Value from growth (how much a company delivers by growing over and above nominal GDP
growth)
...

Discount retailer derives most of its value from rapid growth prospects
...


Rappaport (2006): 10 ways to create shareholder value
 Make strategic decisions that maximize expected future value even at the expense of lower
near term earnings (Look at expected incremental value of future cash flows)
 DO NOT sacrifice sustained growth for short term financial gain such as limiting R&D
spending to meet quarterly earnings benchmark
 Do not manage earnings or provide earnings guidance: Reporting rosy earnings through
value-destroying operating decisions or accounting gimmicks compromise value
...
Outsource lower value activities ex
...

The terminal value/horizon value typically represents 40 to 80% of a technology company’s total
value due to



Minimal profits or even losses during the EPP when the firm is starting operations
Customary presumption that the company reaps most of the returns during the terminal
value period

Gordon formula problem with perpetuity




t to infinity (perpetuity)
But there are never never-ending companies
...
of product
generations that software is likely to remain competitive and viable in marketplace)
Assume 2 product life cycles and that first generation lasts for x years and the effect of your
competitors catching up
More established operating systems like Apple OS and Microsoft OS have more cycles

Gordon formula can also be adapted for serial, finite term diagnosis – 12 to 15 years
EXAM QNS: SSME = Semi Strong Market Efficiency (market is rational and the stock price
reflects all information and the operations/cash flow of the company)
Stock prices may increase due to bidders rushing into stock market to buy the stock
...
(What cost of
capital used, what products/operations/divisions are retained and grown etc)
Valuation driver has to be a mechanism that causes a direct measurable effect on value
...
Value drivers for a hard goods retailer








Company value depends on gross margin, warehouse costs, delivery costs
Gross margin per transaction
No
...
94 correlation

Joven Liew Jia Wen
MSIN3004 M&V Notes
Causal and not incidental: FCF leads to share price
...
Many companies of
the first dot-com bubble had large revenues but they did not manage to make a profit
...
cannot earn a profit since it is only an indication of interest/potential orders
but not actual orders
Surrogates of sales and revenues are bad
Industry-specific multiples are bad too because it is difficult to tell what is a high, low,
average multiple
Easily manipulated as well ex
...
of clicks/visits to the webpage is used to indicate orders
but not necessarily true

Session 5: The Cyclical Urge to Merge

Clark Chapt 1: Next merger boom is already here
Most mergers still fail, based on returns to acquiring company’s shareholders
...
M&A
transaction intensity corresponds approx
...

During expansion periods, management at growing company seeks new sources of external
investment to augment growth from R&D and other internal sources
...
This effect (rising tide lifts all ships)
encourages a misperception that value has been created in the prospective acquiring company,
without effort
...

AOL’s wrong acquisition of TimeWarner in 2000 is an example of using AOL’s inflated share
currency to take the unthinkable deal
...

Deal volume is bolstered by some of the mid cycle failed deals as new targets are suddenly
available for late entrants to buy: one company’s refuse is another’s treasure at the right price
...

Conglomerates were touted in early 1970s as financial value magic
...

BUT there is a 10+ % conglomerate discount imposed by the market
Difficult to achieve synergies to target company and loading the target company with new debt
only reduces level of future investment to remain competitive
...

External investments (Merger/Alliance)
 Advantages: Consolidation type of mergers has prospective improvement in CF, market
power

Joven Liew Jia Wen
MSIN3004 M&V Notes








Augments shortfalls in organic growth
Second core opportunity
If free-standing product, limited additional burden on R&D
Disadvantages: Lower familiarity often means greater financial and operating risk
Will synergies from merger cover APP?
Traditional business may be neglected
Post-merger integration implementation lag

Mergers should be related since they are similar ways to adding to a firm’s asset base and
productive capacity
...

Internal investment (R&D) does not require acquisition purchase premium (APP)
...
Otherwise, present shareholders will not give up their ownership rights
...

Post-1980 merger wave 1 and 1982-90 LBO








Introduction – tentative first steps by early experimenters using LBO
Active Participation – Interest and action by adequately capitalized participants who have
observed that early LBOs succeeded
Major emphasis (monied participants accelerated their involvement and second acquirers
join the chase)
First warning – laggards enter
Second warning – pre collapse
Collapse – singular transaction signal peak
Drift – transition period either to resurrection of boom or shift to divestiture driven market

4 phases of a merger wave
 Phase 1: Economy still perceived as in recession by many
...
Cyclical targets are trading at low
end of P/E multiple ranges
...
Some cheap targets become newly
available as owners lose patience
...
Financing more
available as overall M&A volume grows
...
Signature
event which is perceived by financial markets as fresh and novel
...
Promise begins to push fear away and concerns
about errors of bubbles past are brushed aside
...
Facebook acquisition of Instagram in April
2012 was at a price double the previous week’s market value for that photo sharing services
company
...
Everyone feels that it is now safe to pursue deals again
...


Joven Liew Jia Wen
MSIN3004 M&V Notes
Laggards criticized
...
Chase for hotly pursued target
...
(APP quickly increases to >50%)
 Phase 4: Late cycle deals continue until increasing failures and declining target quality and
reduced merger financing cause exhaustion peak
...
APP soared and the task of first discovering and then
securing sufficient synergies to offset those premiums become nearly impossible
...

LBO (1982-90), Dot com I (1996-2000)
Merger phoenix/economic reset: landmark events in merger wave 4 (2011-19 megaboom)
 Dealing with consequences of preceding cycle’s crash – Repackage consequences
(SADCO)
 Recover green shoots but also doubts – commercial self-interest and market optimism
 Late 2010 Animal spirits re-ignited and new paradigm on horizon: expansion phase of
business-merger cycle
 IPO mania precedes merger resurgence: Pre IPO imagined valuations soar, stimulating
merger boom and market upwards revaluation of established firms
 Mid phases of acknowledged merger boom: fresh appeals to laggards
 Correction/Crash
Shocks, behaviour, operations







Phenomenologists prescribe to the notion that merger activity arises from company
reactions to perceived shocks, threats and changes
Shocks can be overall economy credit rationing, deflation or industry specific shocks like
deregulation in telecommunications
Such acquisitions can be made based on newly relaxed regulations doesn’t mean they have
to be made (lack of management knowledge in new business areas and unfamiliarity with
bidding wars dynamics that hike prices up to buyer’s remorse levels)
Behaviourists believe that merger motivations arise from perceptive of perceptions of
under/over valuation
SSME: Semi Strong Market Efficiency may not hold and share prices may not reflect the
true value of firm
Operationalists will quash the high risk, low reward visionary deals that have worth primarily
in the CEO’s imagination

Merger transaction intermediaries have vested interest as they depend on merger fees and
commission
...

As prices increase with prosperity, so do obstacles to merger success as price vs value
difference widens
...

1982-90 LBOs – High leverage transactions and hostile takeovers (Nabisco)
1996-2000 dot com I – Netscape signature IPO in 1995, friendly takeovers that meant
overpayment with synergies not covering APP, AOL grossly overpaid for Huffington company

Joven Liew Jia Wen
MSIN3004 M&V Notes
2002-08 financial securitization bubble: Extended massive amounts of money to ineligible
borrowers, JPMorgan Chase absorbed Bear Stearns, Merrill Lynch collapsed into Bank of
America
Dot com II (Wave 4)








Led by high tech, began around Mar 2011 when pre-IPO vapor valuation price guess for
Facebook is $100 billion
Corporate $$ (Stockpile cash from 2008-9 recession)
Suppressed interest rates that are kept artificially low by banks due to massive stimulus
Flight to safety (Gresham’s Law): Movement towards anything perceived as tangible like
equities
APP reset (Average APP revert back to about 17% in 2011)
Re-entry of banks (banks are faced with lackluster earnings hence they welcome merger
financing opportunities)
New paradigm business (Facebook IPO, social networking companies)

No social networking (SN) company has yet discovered the secret to keeping the subscribers
and the customers (advertisers) both happy at the same time
...

TAPP = Total Acquisition purchase premium = adjustment to APP taking into acc both
successful acquirer’s bid amount based on pre-announcement prices and also appreciation of
target’s baseline price since beginning of cycle
Synergies related to proposed business combination do not rise with APP levels
No bidder ever knowingly admits to overpayment (implies value destruction from perspective of
acquiring company shareholders)
NRS = Net Realisable Synergies
Compare APP against NRS
In expansive phase of merger cycle, APP tend to increase
...

Overconfidence leads to mistakes in knowing when the exact time arises in phase IV to get out
...
Cheap prices are missed due to acquirer
haunted by possibility of economy slipping back to recession
...

When everyone acknowledges that the boom is on, the expansion period is nearing its end
...


Joven Liew Jia Wen
MSIN3004 M&V Notes

Clark Chapt 2: Debunking 6 merger fallacies that destroy value
6 merger fallacies
 Myth 1: Increased understanding of historical merger failure means that would-be acquiring
firms are more inclined to avoid mergers
 Myth 2: Significant increases to target company’s debt levels do not significantly reduce
probability of related deal’s success
 Myth 3: The heroic figure in acquisition drama is the all-conquering acquirer, while
shareholders of the acquired company are victims, with their firms accurately depicted as led
by underperforming managers
 Myth 4: No inherent conflict of interest between dealmakers and other parties compensated
on the basis of fees earned upon deal closure and interests of acquiring firms’ shareholders
 Myth 5: P/E and similar multiples techniques are the leading merger valuation
methodologies
 Myth 6: PMI success is primarily a matter of sound process and responsive organization

Myth 1: Increased understanding of historical merger failure means that would-be
acquiring firms are more inclined to avoid mergers
FALSE: Though Most mergers fail (MMF), merger volume rebounds when merger sentiment
increases and there is supportive merger financing and a signature event such as a blockbuster
IPO
...
Naïve belief of merger learning that past merger missteps have been learnt
There is egotistical and mistaken contention that each and every merger event is unique and
this justified the tolerance of overpayment and pursuit of doubtful but stylish merger concept
...


Myth 2: Significant increases to target company’s debt levels do not significantly reduce
probability of related deal’s success
FALSE: Piling on extra debt to a company that is already close to its maximum debt level
makes things worse
...

A typical company’s CoE is around 2 to 2
...

BUT there is heightened risk of default and bankruptcy
...

Companies have to be very confident they will not be sabotaged by a sudden dip in revenue or
loss in confidence among creditors that makes them unwilling to keep extending funds
...

In the acquirer-hero column, Gerstner’s culture changing leadership and selective acquisitions
saved IBM and Chambers’ focused acquisitions at Cisco Systems secured the firm’s growth and
dominance
...
AOL-Time Warner is a
bad deal
...
Skype’s 2
acquisitions (first by eBay then Microsoft) showed that it is sometimes better to be on the sell
side
...

Bankers have vested interest to earn merger-related fees and value for shareholders of client
acquiring firms is relegated to secondary consideration
...

If deal pricing results from advance synergy intelligence, deal volume reductions are not
necessary
...

Multiples are overly simplistic and price-to-revenue (P/R) ratio is the most suspect form of
multiple that led to the rise and crash of profitless dot com companies in 1996-2000
...


Joven Liew Jia Wen
MSIN3004 M&V Notes
Multiples are not true valuation methodologies
...
Difficult to
find comparables
...

Important to identify synergies, priorities and achievement – How are post-merger synergies
segmented? Which opportunities within each key division are the largest and most achievable?
Considerations in terms of timing, offsetting costs and investment and implementation feasibility
Only 30% generated synergies on the revenue side that were close to what the acquirer
predicted
...

Revenue synergy shortfalls can result from over-reliance on difficult potential synergy sources
like speculative combined company projects and wrong basis on changes to top-line revenue
instead of incremental cash flow effect

Clark Chapt 3: Merger Megaboom signature IPO Facebook
Bankers perform a pivotal role in M&A; they are the straw that stirs the drink
...

They actively seek to shape the market upon which they rely for their livelihood
...

Envision price necessary to secure control, timing and with realistic net synergies
Today’s CEO is more aware of MMF and the importance of bid price (APP) to realizable
synergies
...

A brand new merger wave means that hundreds of billions of dollars are bet on the new
combined company’s unknown future performance
...

Every merger wave is preceded by a recession
...

Bankers need a sentiment-changing major event to communicate to the world that the financial
markets have moved forward from last recession – Signature IPO of Facebook (May 2012)
Facebook $1billion acquisition of Instagram on April 9 2012

Joven Liew Jia Wen
MSIN3004 M&V Notes
Those supporting the move praised FB for anticipating the sector’s next evolutionary change
towards mobile internet
...

Instagram deal was sector-transformational
...

Facebook-Instagram is the first major acquisition in present M&A wave in which price and APP
considerations were ignored
...
Rising merger transaction volumes support
overall share prices
...
This is due to the uneven distribution of any efficiency gains from the merger
with target company’s shareholders benefitting to the disadvantage of shareholders of
purchasing firm
...

At the beginning of first phase, both share price indices and merger volume are at record low
levels
...

 Increase share price leads to increase merger volume through signature and novel IPO and
post-recession sustained rallies
 Rising share prices inflate acquisition currency (Gresham’s Law dictates that bad money
forces out good in markets)
 As share price increases, pressure to acquire today to avoid being excluded tmr increases
 Concerns that target company become too expensive if they continue to delay
 By acting early, market indices receive upward impetus
 Increase merger volume leads to increase share price due to rising APP trends and
acquisition war chest announced
 CEOs make media proclamations about interest in future strategic acquisitions, making
prices of target companies to rise in anticipation
 There can be 10+ % acquisition anticipation premium
 CEO hubris impaired negotiating leverage since acquiring company CEO showed that he is
too eager
 Implied APPs are factored into share prices of firms, fueling bubbles
Direct merger market effects due to past/future acquisition activity that result directly from
actions of SN companies
...
Google acquired Youtube
...

In an emerging sector with product and service boundaries overlapping and continually
changing, Facebook used its shares as acquisition currency to acquire Instagram
...


Joven Liew Jia Wen
MSIN3004 M&V Notes
Groupon and LivingSocial are still in contention to be online couponing ultimate champion so
they are probably going to have consolidation-emerging type merger
...
Dabbling in experimental
acquisitions can lead to extra costs and lack of focus
...

Continuing shareholders of the acquiring company are most important
Usually, there are many whisper numbers and vapour pricing based on foundations of fake
...
Zealots willing to pay ridiculous amount for a small % of shares  Does not mean that
the company is worth a lot
 The first wave of fanatical buyers overpaying deliberately are not indicative of the full
demand
...
1st merger wave in 1920s ended with Great
Depression
...

Advertising giants Omnicom of America and Publicis of France combined
...
As spirits rise in boardrooms and on trading floors, so
does number of deals and their cost
...
1980s
merger wave ended after the disastrous debt-fuelled hostile bid for RJR Nabisco by KKR, a
private equity firm
...

As many as 2/3 of all mergers and takeovers fail, meaning they do not deliver the benefits
promised when the deal is struck
...

Clark reckons that once a buyer pays a premium of more than 40%, chances of a profitable
merger falls significantly
...
Likelihood of a deal delivering economic benefits is the greatest when
the goal is to cut costs by merging similar firms
...
Google’s purchase of Waze, a traffic
mapping firm and Yahoo’s takeover of Tumblr, a blogging service

Teitelman: Merge or Die
Merger activity will get a much-needed lift when companies realise that acquisitions are the only
way to expand in a slow-growth economy
Shift from stakeholder to shareholder governance
Waste and destruction of M&A
In 1974, Morgan Stanley advises Inco (nickel mining giant) to make a bid for ESB (battery
maker), opening up business of hostile tender offers and M&A was unleashed
...
Business is slow
...
The effort required to buy another organization –
negotiate a price, perform effective due diligence, resolve legal and regulatory requirements and
defeat other bidders – is daunting and time consuming, high drama and remarkable tedium
...

Postmerger integration = how to effectively knit two corporate entities into one

Joven Liew Jia Wen
MSIN3004 M&V Notes
Risks of M&A are considerable and many companies are still focused on disaster and
seemingly content with accumulating cash and passing some to shareholders when they are
restive
...

Expansion of M&A into middle markets and into the developed and emerging economies led to
larger waves
...

M&A will revive when both companies and investors feel that they have no other option for
growth
...
Corporations and investors now hold record piles of cash that are available for
investment and much of it has yet to go to CAPEX or M&A
...
Eventually, many companies will have to turn to other
sources of growth: new technologies, new businesses, new geographies, new products and
possibly M&A
...
M&A emerged
as a powerful engine of restructuring and revival for a corporate sector widely viewed as
sclerotic and crippled by conglomerates
...
80s ended with a recession but M&A bounced back with each leg
bigger than before
...
By mid 2000s, M&A was producing volumes driven by private
equity
...

In 2011, US M&A surged a little then in early 2013, Dell management buyout, Bershire
Hathaway teamed up with Brazil’s 3G Capital to buy H
...
M&A is by its very nature a
bullish business
...

Confidence fuels growth and growth fuels M&A but confidence is not there
...

Fed’s QE program sent equities surging to record heights has impeded arrival of M&A
...

Furthermore, activists have been aggressive proponents of having companies leverage
themselves to engage in buybacks, recapitalization or dividends
...

Wall Street gets larger fees from larger transactions thus providing a motivation to press for
bigger deals
...
Current
cycle began in 2011
...
Signature phase 1 deal was Facebook acquisition of Instagram for $1bn in
April 2012, immediately before Facebook IPO (just like 1996 Netscape IPO that kicked off the
Internet mania)
Phase 2: Conditions ripen, stock price rise, financing becomes more available, deals occur in
stops and starts
...

Consolidation deals like Omnicom and Publicis, with $500 million synergies and virtually no
premium are prudent phase 2 deals
...

Phase 4: Steep premiums, some above the 40% alert, scramble to get into the game before it
ends
...

Social media and e-commerce offerings that will follow Twitter – led by Chinese companies like
Alibaba and Sina Weibo, that can list on NYSE will set off an acceleration in M&A
...
But Clark believes
that factors crippling M&A will give way to renewed hunger for risk and growth
...

Bain argued that frequency matters
...
Second, materiality mattered
...

Companies that made infrequent big bets fared more poorly
...
Experience is important
...

Past performance is no guarantee of future results
...
A mistake within first year of launch)





Almost no market penetration, made worse by tech problems
Expected duration of TVP is 1 year, desperate actions to re-positioning give the wrong
signal
New product launch disappoints from the onset
Preservation of capital assumes priority role

Possibilities of happening  AA: Ideal (50%), AB: Dark Model (35%), AC: Black Hole (15%)
Average company lasts about 7
...

Scenario valuation estimates require additional adjusts for other factors (Multi scenario
applications)
 Feasibility: Ease of implementation in the organization as it exists today with current
resources (whether there are capital constraints)
 Launch timing: Even minor delays in launch schedule change the valuation of that scenario
 Capital constraints: Absolute limits to cash availability may favour smaller initiatives
Expected Economic Return (EER) Basis: Outcomes from the 3 scenarios are multiplied against
the analysed weights in developing a EER composite
Gordon formula’s limited vriables means that minor changes to any exert exaggerated effect
...

Perpetuity should be replaced with a much briefer limited term assumption for the duration
...

Underlying product life cycle (PLC) approach



Estimate the total no
...
Today dominated by DCF2S except for pure utilities
...

Merger valuation is the determination of whether or not the deal is successful from the
perspective of the parties putting up the risk capital, in this case is the continuing shareholders
of the acquiring company
...
2/3 of mergers fail
...
CFROI> WACC






Extension of viability threshold: Extending the firm’s corporate value lifespan (CVL)
Extending period which CFROI> WACC
Mobilise advantage and fully exploit competitive and value advantage
Maximise value in contention and participation phases of CVL
Minimize ongoing WACC

EXAM QNS: Does EPS work for mergers?
EPS is easy to calculate and no future projections required but EPS increases for bad deals
now too due to changes in accounting basis hence EPS does not work for merger
...

Emphasis on EPS is myopic and can be value destructive
...
Cash flow correlates almost perfectly with company
share price movements
...

Kellaway’s Paradox: If Goldman Sachs wanted to demonstrate its commitment to client wellbeing, it would close down its M&A department given the massive evidence historically that
majority of acquisitions have not worked out
...


Joven Liew Jia Wen
MSIN3004 M&V Notes
The bankers get the fees and the top management of acquiring company get the blame for most
failed deals
...

Net Realisable Synergies (NRS) fall short of premiums in most deals, causing a merger failure
based on returns to acquirer’s shareholders
Mergers fail because




Select a wrong target that make little sense to financial markets
Pay too much for it (good company bad price)
Poorly integrate it (major synergy opportunities are squandered)

However, people still go back for mergers because





They think they are the exception that can find the successful transactions
Look for alternatives of inorganic growth since organic growth such as product line
extension and expansion to other geographic areas are used up
Spending imagined wealth: Stock market boom leads to prices of all companies to rise and
acquirer feels that they should do something with their high stock price
Acquiring company CEO hubris: Presiding over a major acquisition during his period seems
good

7 Keys to Merger Success (KTMS: Keys to Merger Success)
 Following the right merger success criteria (success is not a closed deal but from
perspective of continuing shareholders of acquirer company)
 Optimal timing within the merger cycle (late phases of 3 and 4 exaggerate the threats to
merger success since there are diminishing supply of quality targets and APP is high)
 Exploiting the superior understanding of merger segmentation
 Adhere to absolute and relative limits of APP (premiums above 38% require extra scrutiny)

Joven Liew Jia Wen
MSIN3004 M&V Notes
 Bid pricing integrated with in depth 4 synergy type PMI investigation (bid process that is
undisciplined by realizable synergies is vulnerable to value destructive acquisition over
pricing)
 Synergy elements (real distinguished from vapor)
 Avoidance of transaction by wounded quail acquirers and overreaching ego (ego
acquisitions are the worst deals)
Following the right merger success criteria (central issue of returns over acquisition lifespan to
acquiring company’s shareholders)











Two emerging methods (Value Gap or Incremental Value Effect)
Criterion is a principle or measure by which something may be evaluated or decided
Credible evaluative measure is codified, consistent, fact based rather than opinion based
and it optimizes the critical performance objectives of the criteria-setters
No stake in merger to have an objective point of view
Cannot lead with measure first
Nomination of vague subjective criteria can make it impossible to define specifically
Cannot use spurious concepts that are absolutely wrong (diversification in company that
leads to conglomerate discount)
Must maximize shareholder value on the continuing basis
Do not take irrelevant topics assume center stage (all cash vs all stock)
Important who is the one doing the valuation: If people have a stake in the game, valuation
cannot be accurate

EXAM QNS: 4 leading merger valuation methods
 Event Studies (ES): most extensively applied over past 30 years which shows that acquirer’s
share price usually falls and acquiree’s share price usually rises but it does not take into
consideration directly the synergies involved
...
Returns based on increase in market capitalization over time period
...
It assumes well
developed PMI
...

 Incremental Value Effect (IVE): Two separate companies’ valuations compared as
standalones or combined including APP and S
...
May have unrealistic projections of synergies etc
...
Only a few cash payback deals
...
Deals limited to cash buyers
...
All acquisitions are still considered risky
...
Exhaustion peaked
...
Higher APP and imminent deterioration of economic conditions
...
APP soars over 100%
...

The acquiring firm’s analysed WACC is the minimum acceptable return rate
...

Event Studies (ES) is widely cited by academic researchers but dismissed by merger
practitioners







Developed from readily available data
Dominant method in academic research
Look at acquirer’s pre and post announcement share price trend relative to index or industry
comparables
Source of data: share price
Would be acquirer’s share price almost always falls and target’s share price rises when
acquirer expresses purchase interest in target
Short term stimulus and thus trading speculation means that concept of market efficiency is
at work

Joven Liew Jia Wen
MSIN3004 M&V Notes










Merger efficiencies such as scale economies and elimination of overlapping costs accrue to
the target in the form of APP since benefits from the combination accrue disproportionately
to the selling company in the form of APP
By ES, a merger deemed successful is when acquirer’s share price eventually makes up for
its early deficit
But if bid is too high that synergies cannot possibly offset the purchase premium or financial
markets have little confidence that management can achieve those synergies, the buying
company’s share price slump continues
...
Shorter duration ES means that success of a specific deal depends only on a few
months of price data but post-merger period is still in effect one year after the closed deal
...
Acquiring company’s share price is
not a single issue referendum on the success or failure of any specific merger deal
...

Isolating price effect of a single merger transaction is difficult the longer the ES time period

Total Shareholder Returns (TSR) is suitable for short-term owners who make limited changes to
target before attempting to resell the company a few years later (Permanent ownership is out of
the question)
















Supplemented with cost of capital reference
Indication of returns as perceived by acquiring company’s shareholders but extreme
dividend payouts can distort the measure
Returns based on increase in market capitalization over time period, compared to WACC
Success depends on whether the total annualized return over the ownership period exceeds
WACC following the re-sale of target shares
Buy and sell sequence
Difference in share proceeds + dividend received are transformed into an annualized rate of
return over period of possession
Returns are expressed by change over time in market capitalization
TSR = (Share price appreciation + cash dividend) / investment time period
Source of data: share price
Easy statistical calculation
Periods of temporary target company ownership differ so comparing TSR is difficult
Excludes most successful acquisitions which are often retained permanently by operating
company acquirer
For company that buys the target and holds on to it, TSR ratio does not answer whether
deal is a success
Company with identical worth based on CF which is bought at different timing and unload at
a boom or recession will have different TSR even though underlying worth of company didn’t
change
Furthermore, increase in dividends is indicative of improving performance but round turn
acquirer can distort dividend outflows to maximize its self awarded fees and extract
excessive funds from acquired company (value destructive)

Joven Liew Jia Wen
MSIN3004 M&V Notes







Problems arise when dividend payouts are bloated to include extraordinary distributions to
the new temporary owners hence we should adjust for extraordinary and non-recurring
dividend and use dividends that are limited to historical trends
Compare TSR to WACC (for Transitional owner, use WACC of target company)
Transitional owner may destabilize target company by piling on debt to become highly
leveraged
Round turn transactions and duration are very deal specific, comparisons between TSR is
difficult since company can be acquired at the beginning of phase I or at late phase IV
Market capitalization results are subjected to timing (TSR can be artificially inflated by
booming market conditions)
Primarily limited to financial acquirers, for which returns per transaction (RT) and investment
turn velocity are important

Long term buy-and-hold acquirers are better served with VG and IVE
Value Gap (VG) = Acquisition Purchase Premium (APP) – Net Realisable Synergies (NRS)
























Most visible broad measure of merger success
APP – PV of realizable merger-related synergies
NPV of the acquisition decision
Source of data: CF and Initial SP included in APP
For a merger to be successful, synergies must exceed APP paid
Incorporates DCF since projected synergies from the envisioned business combination are
discounted back to the present, ideally at WACC
APP is calculated on a 2 month pre announcement basis
As merger cycle ages, escalating APP (close deal regardless of price) becomes more
difficult to be offset by synergies that remain unchanged
If realizable synergies shrink due to actions such as timing delays of PMI or unworkable PMI
and APP remains unchanged, value gap widens
...
Good
Company Bad Price (GCBP)
CEO overspends to secure ownership of star-quality target company
CEO that loses acquisition bid is not a loser: Barclays avoided a disastrous acquisition of
ABN Amro to RBS
Must have sufficient synergy intelligence to guide bidding process
Bidding groupthink is not as good as synergy intelligence
Limitations: Presume well developed PMI synergy diagnosis and implementation capability
Zero or negative VG does not always ensure successful acquisition since there are other
factors that contribute to merger failure

Joven Liew Jia Wen
MSIN3004 M&V Notes


Increasing visibility and use as secondary financial measure

Synergies (FERM) result from both operations and execution as there is limited time opportunity
in critical PMI period (some synergies like IT consolidation takes years to fully accomplish
therefore discounting these inflows back to present value allows NRS to take into consideration
time)







Expense synergies
Revenue synergies
Financial synergies
Management-related synergies
NRS remains almost unchanged throughout the cycle
APP > NRS usually because of bid chase to value destruction, deficient synergy intelligence,
consistency with MMF, selling company wants to set higher min bid
 Guessing imagined synergies without factoring feasibility, time delays and offsets is selfdelusional

Incremental Value Effect (IVE) = DCF company value comparisons, standalone vs combined










Damodaran’s standalone vs combined post-merger company DCF merger valuation
Are shareholders of acquiring firm better off proceding with the deal or better off going alone
Comparative DCF analysis of acquirer and target standalone future vs combination with
synergies
Hybrid DCF discount rate for merged firm indicates the analysed post-merger WACC
If NPV for proposed merged firm is higher than the NPV of separate companies to the extent
excess returns exceed acquirer’s WACC, deal is successful
Evaluation of success centers on the comparison of involved companies’ worth pre- and
post- combination basis, including NRS and APP in the latter
IVE has two alternative scenarios developed and compare NPV (using full future lifespan of
both companies and combined)
Source of data: CF and initial SP included in APP
Limitations: possible inaccuracies with unrealistic projection model, components and misdiagnosis of value drivers

Both leading methods VG and IVE require multiple projections and assumptions but they are
aligned with the interests of the continuing shareholders of the company
...

Combination of VF and IVE is the preferred merger valuation approach
...

Subjective merger motivation can be excessive CEO pride/hubris, personal prestige and a
desire to expand acquiring company’s asset size and market presence or pursuit of a target that
suggests subjectively appealing good strategic fit
...

MMF: Most mergers fail
Smithburg (Quaker Oats/Snapple), Chandler (Unum/Provident), Allen (AT&T/NCR), Apotheker
(HP/3Par)

APP component of Value Gap (VG)
Value Gap is the primary basis for evaluating individual merger transaction success
...

2/3 of all mergers fail
...
Narrow
specialists steer PMI towards their favourite topic only
...

APP calculation involves two elements





Actual or intended bid price is often disclosed in public announcements
...

‘ Market value’ reference point or ‘undisturbed price’: In runaway bull markets, share price of
even mediocre targets triple with negligible improvement in the ultimate source of corporate
worth, internal cash flow generation
...
A tide lifts all boats
...
Merged entity is expected to
save about $300 million in annual operating costs and shared manufacturing and design
expertise will be useful
...
Takes at least 12 months for clearance and deal may be
blocked altogether or with remedies that undermine the logic of the tie-up
...

A 302 million pound fee has to be paid by Ball if anti-trust authorities block the merger
...

Synergy is the additional value that is generated by combining two firms, creating opportunities
that would not be available to these firms operating independently
...
They show up as higher expected cash flows
...

become a bigger steel company)
Greater pricing power from reduced competition and larger market share resulting in higher
margins and operating income (create oligopoly with pricing power)
Combination of different functional strengths (a firm with strong marketing skills acquire a
firm with good product line)
Higher growth in new or existing markets (use the acquiree’s established network and brand
name recognition to increase sales of product)

Financial synergies are more focused and include tax benefits, diversification, a higher debt
capacity and uses for excess cash
...
Present value of synergies is important
...


1st: Value firms involved in the merger independently, by discounting expected cash flows to
each firm at WACC for that firm
...

3rd: Build in effects of synergy and revalue combined firm with synergy
...

Value synergy in a DCF framework



One-off cost synergies increase value by present value of savings
Continuing savings increase value by present value of resulting higher income and cash
flows over time

Joven Liew Jia Wen
MSIN3004 M&V Notes



Cash slack in merger is NPV of projects that cash-poor firm was forced to reject because of
cash constraints that can now carry on
Present value of tax savings

Value the two firms independently and the value of combined firm is sum of firms valued
independently
...

P/E ratios are irrelevant to whether merger is good or not
...


Need to track mergers after they occur and evaluate success of firms in delivering synergy
gains
...


Joven Liew Jia Wen
MSIN3004 M&V Notes
Market usually impounds its expectations into the stock price
...





Biased evaluation process: assessment of whether deal makes sense is done by deal
makers (bankers with vested interest on commission fees
Managerial hubris: acquiring firm’s managers consistently overestimate the value of
synergies since they think they are better than the average and are immune to mistakes
(overconfident CEOs)
Failure to plan for synergy: do not have explicit plans to deliver synergy

Cost-saving mergers have a better chance of succeeding than mergers based on growth
synergies
Rmb to use combined firm’s WACC

Coley & Reinton: The Hunt for Value
Good evidence that most mergers have failed but there are some companies that have
consistently made acquisitions that generated shareholder value
...

Some sizable acquisitions turned out poorly enough to drag down parents’ long term
performance
...

The larger the acquisitions, the greater the diversification, the smaller the likelihood of success
Often, managers paid too much for their acquisitions and could not introduce enough financial
or operating changes to offset the premiums
...
Imperial Group paid a (then record) $630 million for Howard Johnson in 1980 which was
double what the market price was earlier in the year
...
5% and
eventually sold it to Marriott for $314 million
...


Joven Liew Jia Wen
MSIN3004 M&V Notes
A discounted cash flow analysis cannot justify because market has realized their appeal and
marked up share price
...

Successful acquirers






Reorganize new subsidiary to offset high cost of purchase
Beef up its operations
Systematically identify and assess value created by merging
Carefully manage integration process afterwards
Infusion of talent that leads to reduction in working capital

For acquisitions at prices above 40%, companies employ financial engineering such as
redeploying assets through spinoffs, capturing hidden asset value and selling property
...
They update the portfolio of the business when opportunities arise and
companies that renew from within move into new areas only when they see some way to exploit
skills they already possess
...


Expedia’s acquisition of Orbitz online travel website
Value Gap (VG) comprises of 2 components
 Analysed net Acquisition Purchase Premium (amount of % paid in excess of firm’s preacquisition market value as approx
...

Orbitz was off merger radar prior to its announcement that the company is for sale therefore the
date becomes the initial date in APP calculation
...
Synergy guess is more
hope and hype than facts
...
It will provide additional customer traffic and healthy
cost savings
...
Expedia share price rose
...

Non-consummations ex
...

Non-consummations are not failures (Clark)
Rupert Murdoch’s 21st Century Fox made a bid of $80 billion to buy Time Warner
...
History suggests that he wouldn’t give up even if he destroy
value by offering more
...

Current offer would take the combined company debt to 4 times EBITDA after accounting for
synergies
...

Value destructive deal-making is nothing new under Murdoch’s reign
...

Other giant deals failed as well
...
of big mobile operators from 4 to 3
 They propose deals that challenge limits of their balance sheets and patience of investors
(Murdoch was offering takeover premium of $20bn, leading to falling share price)
Failed transactions have lasting consequences
...


Joven Liew Jia Wen
MSIN3004 M&V Notes
The key is to re-establish momentum to demonstrate strong operating performance
...

Prudential PLC failed a takeover bid for AIA but Prudential boss rebuilt his reputation by
doubling operating profits
...

BUT CEOs have to do well in both dealmaking and the mundane task of boosting earnings to
please the shareholders
...
Everyone only rushed in once the merger
wave is legitimized
...
Murdoch is
destroying value by buying print media at high price
...
Sometimes, the seller wins
...

Sellers market is when sellers are in dominant position and ask for high price, APP becomes
high
...
Yahoo buying Tumbler
...
T-mobile not
allowed to combine with Sprint
Looks bad on CEO if all the acquisitions fail and have 2 non-consummation
Increase in non-consummation shows that people understand more about VG and there is
winning by walking away (Barclays benefited from not winning the bid of ABN Amra from RBS)
NewsCorp board of directors is alarmed since Murdoch has made major acquisitions that
destroy value so they rose up against him and stop him from acquiring TimeWarner
Winner’s Remorse: Win by closing the deal (based on banker’s perspective) but it destroys
value due to overpayment (based on VG methodology)
Winning by walking away: Nonconsummation is a better option according to VG
Now it is a sellers market since Carl Icahn has been buying small stake in potential companies
and steering them to be acquired

Lecture 6: Merger success
Acquisition of Orbitz by Expedia (both are electronic travel sites)
In 2nd half of the merger cycle, share price soared so APP based on recent share price will look
small
...

Sometimes, due to wrong reference point for calculating APP, people thought they have excess
synergies compared to APP
...
There were 4 distinct
waves
...

VG = APP – NRS
For APP, in the 2nd half of the merger cycle, must look at share price 10/20 sessions back to
remove insider trading and reach the day the acquirer first express public interest of the
company
...
Above that, MMF
...

CAPE: Cyclically adjusted price/earnings indicator
Buffet indicator
EXAM QNS: What is NRS?
EXAM QNS: APP & Market efficiency
Mergers are efficient because there is better utilization of assets
...
but
benefits usually come in the form of APP to the seller
...

Perspective of merger success: FOCUS on continuing shareholders of the company and not
activist shareholders
...

Convergence of several factors lead to merger megaboom







Corporate stockpile of cash
Suppressed interest rates
Gresham’s law
APP reset
Re-entry of banks
This cycle’s new paradigm business: Facebook and Dotcom II

4 phases of merger cycle

Joven Liew Jia Wen
MSIN3004 M&V Notes





1st phase: APP is 10 to 18%, best time to have M&A, people still think they are in a
recession
2nd phase: APP is 20 to 35%, Buying Instagram by FB, companies still waiting for others to
do something
3rd phase: APP> 50%, laggards, merger boom legitimized
4th phase: APP> 100%, late cycle deals, declining target quality, reduced merger financing

AOL buying Huffington Press is the worst deal
 APP > 100%
 No synergies
A lot of the mergers are consolidations like pharmaceutical company buying pharmaceutical
company
...

Sometimes, in the 2nd half of merger cycle, there are demergers to add to supply of acquisition
targets
...

Most of the synergies are expense synergies 65% then revenue synergies 20% and
tax/financing synergies 15%
...
4% then later at + another 7
...
Above 38% is overbidding
...
’
Multiples are only a back-up merger valuation approach
...
Simplest of financial metrics and present spot price fails to
identify depth of potentially value-destructive overpayment by buyer
...

Acquisition under Value Gap











Correctly perceiving any bid over MV as value-destructive
Maximum bid analysis governs, constructed from most conservative realistic approach
No new paradigms
Avoid chases that introduce ego-bid distortions
Winning by Walking away is an option
Bid timing not when financing is most available
At least 70% of acquisition bid is dependent on expense side synergies
Revenue synergies is more of expanded channel opportunities
Avoidance of destabilizing debt that depresses company value for short term cash
generation (Zell, Chicago Tribune)
Avoid misleading celebrations at closing

Coaster company with 6 P/E




BU 1: Digital media/high tech business (CF: 700 that can quickly grow to 1000, 70 P/E)
BU 2: Poor business unit like dial-up services or newspaper business (CF: 100 to 0)
BU 3: Operating business (CF: 400 to 600 with cutting expenses, radical focus, 12 P/E)

Tutorial 5: 7KTMS (Keys to Merger Success) EXAM QNS
5th: Bid Pricing integrated with In-depth Four Synergy Type PMI Investigation
A bid undisciplined by realizable synergies is vulnerable to value-destructive, success-reducing
acquisition overpricing
...
Primary
reliance on the most substantial parts of the two most reliable synergy categories is e and r
...
Apotheker
...
How long it takes for
synergies to be realized? Present value effect
...
Void fill is like top revenue benefit, channel
filled
...
It is the Present Value of synergies that matter for VG
purposes rather than gross amounts
...

Each of the 4 distinctive synergy types is unique and need to understand the differences for
an adequate PMI effort
Recheck the PV synergy math of Revenue synergy (Not all Revenue synergies will be
translated to CF and dramatic new offerings for customers etc
...
WACC may fall
...


Joven Liew Jia Wen
MSIN3004 M&V Notes
Management synergies: notoriously vague and acquiring management tend to revert to explain
the persistent deficiency in terms of improvement opportunities by better management
Acquiring CEO hubris since every acquiring management sees itself as superior
...
For the merger to work,
the acquiring investor must achieve additional value in the newly created business combination
...

*Synergy, the increase in value that is generated by combining two entities to create a new and
more valuable entity, is the magic ingredient that allows acquirers to pay billions in premiums in
acquisitions
...

Need to investigate synergies to know whether the deal succeeded
...

Duration of synergy period is relevant



One-off action like cost reduction is misdiagnosed as exerting a continuing beneficial effect
on combined company
Furthermore, some expense and revenue synergy benefits with a finite duration may be
mistakenly calculated as continuing forever

Joven Liew Jia Wen
MSIN3004 M&V Notes
Expense synergies ~ 65%, Revenue synergies ~ 20%, Tax and financing synergies combined ~
15%
Azofra-AMS APP of 38% over pre-announcement market capitalization
The acquirer reaches that final bid level in two bidding stages, 1st representing about 8/10 of the
bid maximum in case seller is enticed by bargain deal then followed by remainder in 2nd bid
...
Same
APP percentage applied later in the merger cycle is bigger
...
Mangers have
insufficient know-how of key target areas and how to extract max synergies
...
)
 Feasibility adjustments
 Timing slippage (Target synergies will take longer to achieve than thought
...
Acquirer destroys value
...
They show
up as higher expected
cash flows
...
Competitors may want to lure away key
talent or corporate key contributors (CKCs) and major accounts
...
Need to develop counter strategies
...
Hence, now that transaction is closed, need to
determine true synergy situation
...
Sluggish pace in implementing reforms threaten deal success
...

 Achieve quick wins in 1st quarter of PMI: expense synergy like scale efficiencies can be
achieved to cut down on excess capacity
...
High
visibility of these synergies makes nervous investors satisfied
...
Internal analysts fear that pointing
out fallacies is a fast track to unemployment
...
)

Clark & Mills Chapt 8 on Bid pricing integrated with in-depth 4 type synergy
PMI investigation
Maximum APP that may be justified in the bid has to do with the present value of realizable
synergies, adjusted for offsets, synergy duration and feasibility requirements, implementation
delays, relating to the 4 categories
...

In the absence of consistent and complete synergy insight relating to the deal overall, APP will
soar to ridiculous heights
...
Early diagnosis is necessary to
ensure that the APP for the target is likely to be justified based on expected NRS
...
Even after closing, such critical intelligence is difficult to extract
...

Base of triangle: E and R synergies can be achieved without other contingent developments
and conditions
...

Middle tier: E and R synergies that are not sure things but accurately depicted as probable,
depending on presumed efficiencies and plant’s remaining economic life
...
Experimental saving
concepts and chancy new revenue concepts
...

Due-diligence process failed to head off bad takeovers
...
Many said that they routinely failed to achieve all the synergies
that have been identified before the takeover
...

Only 30% generated synergies on revenue side were close to what acquirer had predicted
...
Only 12% of acquirers managed to
significantly accelerate growth over the next 3 years
...

Many synergies aren’t possible due to environmental factors and how competitors respond to
takeover
...

Synergies are seductive because they promise something for nothing
...

Some synergies are obvious: can cut costs by combining similar companies
Successful examples: Banks found cost synergies by merging and closing branches that
duplicate customers’ base, Cisco Systems Incorporated has consistently produced revenue
synergies by buying small companies and adding their products to the portfolio of Cisco’s sales
force
Unum Corporation (largest provider of disability insurance for groups) and Provident Companies
(largest provider of disability insurance for individuals) merged, logic seems good (a combined
company that span a whole range of types of disability insurance)

Joven Liew Jia Wen
MSIN3004 M&V Notes
They thought of all the potential synergies to reach to people not covered by any disability policy
and company become more efficient, saving on costs, with better services and lower costs
...

















Unexpected expenses related to the merger
34 separate information systems that are not integrated within the combined company
Information systems are an especially large obstacle
Sales force didn’t cooperate and didn’t want to sell each other’s products
...
Demographics of
customers are different
...

Synergies may appear in minds of strategists but not in the minds of customers
Excitement over prospects of synergies can cause company to overpay
Clash of culture, skills and systems can mean that synergies that seem easy to achieve are
impossible to get
Many costs you expect to eliminate just move to a different budget
Many costs stay because of the inevitable compromises in a merger
Many people have a vested interest in seeing synergies not realized
...

Need incentives to get people to change and pay change-management teams
Companies frequently overestimate the amount they can streamline a process after
takeover
Companies routinely overstate their advantage over their competitors

Ex
...

Quaker Oats Company also overpaid for Snapple Beverage Corporation
...
Software may be faulty,
operations are sluggish and management is overwhelmed
...


Lecture 7: Synergies
EXAM QNS: How might failure to adjust for speculative excess in the stock market distort ES
results?
Event studies (ES) looks at market reactions to the announcement
...
The market speculates who is the next target for acquisitions and stock
prices increase
...
If seller knows that there are synergies, they will raise the price
...
’
Exclusive means that ‘only I can buy from you’ but this results in overpayment as the acquirer is
paying in order to win the bid, with no considerations of the synergies involved
...

Current P/E is just a historical relationship of share price to EPS
...

Usually, PMI is shortened to a year or half a year
...

Bottom trawler: companies going out of business and asking for offer price
Mergers of equal: 2 very large companies come together with zero APP
The seller usually does better than the buyer, esp when it is 3rd or 4th phases of the merger
HP acquire Autonomy/3 Par, AOL TimeWarner were very bad
...
Long term Event Studies are affected
by other factors too and difficult to isolate one acquisition event
...

Synergies are once dismissed as M&A analytical fluff but synergy development is today viewed
by most as critical to merger success
...

***Nearly every deal requires APP and under VG method, synergies offset those deliberate
overbids
...
There will be winner’s remorse and CEO think that they are legends in
their own minds
...

BUT they may be blind to offsets and internal department usually exaggerate promised IT
synergies to get bigger merger budget and there is an absence of accountability since no one is
actually sacked for not achieving synergy targets
...

NRS offset and timing










Need to check if it affects cash flow
Offset not articulated does not mean it doesn’t exist
Hidden offsets
Defensible determination of actual duration of the synergies
Sacking of employees is not savings forever
Timeframe of synergies is important, tax synergies don’t occur forever, sometimes
governing authorities don’t allow for tax inversion
Delayed initiative will affect value of synergies
Need to take into account dependency on other developments
Expected economic return (EER) basis is most favourable

Synergy conventional wisdom is 2 + 2 = 5 (positive combination)
But sometimes in reality it is 2 + 2 = 4 or even 3 (synergy is over-hyped and over-estimated)
Negative synergy ex
...
Starbucks, Apple
You do not want a very well-run and operated target company
...
A well-run company has little
synergies
...

Great volume and diversity of research supporting MMF: 3 McKinsey & Co multi-company
merger performance research studies, articles by Magnet, Coley and Reinton, Bieshaar et al
There is no effective refutation of MMF

Joven Liew Jia Wen
MSIN3004 M&V Notes














Proponents of qualitative, mostly motivations-defined criteria for assessing merger success
or failure ex
...
Healey et al
argues that operating performance improves as a result of mergers
There is chronic limitations in Healey’s sample set and absence of any consideration of APP
and lack of reference to comparable rates of return
Suggested criteria is post-merger accounting data to test directly for changes in operating
performance that results from mergers
This is similar to ES except that Healey et al looks at post-close changes in combined
corporation’s future cash flows
Healey’s sample is insufficient in terms of sample size and analysis time period, leading to
distorted conclusions
All Healey’s 50 transactions occurred during the pre-Reagan recession in 1979-84 since
merger cycle was at a low ebb and APP was low
An external merger investment analysis is incomplete and unrealistic when it excludes the
full cost of that asset

The urge to merge is a permanent part of firms’ value growth strategies
...

Top 4 types of mergers in terms of success probability
 Bottom trawlers: Dying competitor signals exit, advantage to fast, cash bidders ex
...
P&G/Pantene
 Line extension equivalents: Next generation/different variant of existing product/service ex
...
Pharma,
telecoms
Then followed by multiple core related complimentary then consolidation-emerging and single
core-related complementary with correct opportunistic timing
Speculative and strategic acquisition type mostly fails
...
AOL and Time Warner
MMF only coincides with the financial interests of a limited range of stakeholders in the M&A
process
...
They wish to see pursuit of maximum
shareholder value and they avoid low success probability deals and limits APP to 38%
...
They
want to maximize ongoing M&A transaction volume and thus fees
...

Hayward’s 3 causes of merger failure
 Select the wrong target: Aiming at the wrong target assures a value-destroying acquisition
resulting in negative synergies where 2+ 2 = 3 ex
...
HP/3-Par, RBS/ABN Amro,
AOL/Huffington Press
...
AT&T/NCR (no PMI guidance for 2 years) and
Terra Firma/EMI (key performing talent resist new owner’s ideas of running the business)
Poor synergy intelligence means that acquiring company is bidding blindly
...
These studies show that shareholders of buyers generally earn
the required rate of return on investment
...

Bruner believes that all M&A are local
...

Big deals by nature have more integration and regulatory problems
...

One often hears that M&A deals are undertaken for vague strategic benefits, creation of special
capabilities or simply because the 2 CEOs are friendly
...
The decline in share price had
little to do with merger at times and has got to do with external factor
Cannot know what will happen if the acquisition did not occur since the acquisition sometimes
give the company a new future and remain competitive
...

Burner believes that contaminating events, overvalued stock and industry shocks can lead to
misleading thoughtful practitioners to believe MMF
...

Some entrepreneurs seize opportunities created by the turbulence to make a profit
...
Ex
...

5 main forces of merger process: regulatory reform, technological change, fluctuations in
financial markets, role of leadership and tension between scale and focus
All M&A are local suggests we examine forces at work in a particular business setting
...
(strategy, market segments, deal design and governance)













One of the determinants of M&A profitability concentrates on strategic choices including
attempts to diversify the firm, grow the firm and build market share
...

Diversification leads to conglomerate discount of 8 to 15%
Strategic linkage pays in M&A
M&A will pay when synergies are credible
Value acquiring pays but glamour acquiring does not
Segments that tend to be profitable for buyers are privately owned targets
Foreign targets that are consummated during ‘hot’ market conditions are more costly to
buyers
Targets that can be restructured suggests more profitability
In cases where payment is in cash, target shareholder returns are considerably higher
Merger of equals are mergers that combine partners of roughly equal influence without
payment of premium to each other usually increase probability of success
Return to buyer firm shareholders are associated with larger equity interests by managers
and employees
Practical value of M&A research lies in the local conditions associated with the creation or
destruction of value

Joven Liew Jia Wen
MSIN3004 M&V Notes

Clark: Most mergers still fail but that won’t derail the latest merger boom
Merger boom started with Facebook’s shock acquisition of Instagram before its May 2012 IPO
at double the price a week earlier
...
Google bought Waze and Yahoo
bought Tumblr
...

Factors that drive merger booms: Corporate $$ due to stockpile cash from recession,
suppressed interest rates, Gresham’s law, APP reset, Re-entry of banks that welcome merger
opportunities, this cycle’s new paradigm business

Upgrade M&A acumen by improving merger segmentation, timing and synergy diagnosis and
implementation
...

Hence, companies look for external source of growth: mergers
 Spending imagined wealth: In market booms, prices of all companies tend to rise, acquirer
and target alike
...

 Acquiring CEO hubris: Presiding over a major acquisition remains a driving force and new
CEO has little doubts about his ability to beat the odds

Love on the Rocks – Merger of Equals rarely lasts long
Publicis and Omnicom, two advertising giants, would not merged after all
...

When Travelers and Citibank unveiled their merger of equals, both co-CEOs fought
...

Similar size of firms makes it difficult for either boss to make a convincing case for taking sole
charge and bosses tend to have huge egos and wouldn’t be able to share power
...
Competitive speed is lost as everything has to be checked
...


ATD: Most important and effective anti-takeover defence approaches and
methods
Anti-takeover defences (ATD) rose to prominence during the LBO wave
...

EXAM QNS: Which deterrent approach is the least effective in terms of maximizing chances of
target firm to remain independent while still publicly traded?
Green mail: Solicit a bribe and can be sued by shareholders
...
Get nothing
...
Men’s Warehouse vs Jos
...
A Bank but Jos
...

Resulted in bidding war and the higher the bid, the more likely it will fail
...
Company
is still involved in a merger it doesn’t want
...


ATD
 Charter amendments: structural barriers that require voter approval
...
Facebook founders want to protect share interest of founders and don’t want other
people to takeover)
 Poison pills: target company statutes that activate adverse consequences based on change
in ownership as designated by existing management
 Payment to shareholders (share buyback to increase share price and reduce float that is
otherwise available to potential acquirers, make it difficult for acquirer to accumulate
sufficient shares)
 Greenmail is a form of bribe or payment to make the suitor go away: illegal in most forms
 Asset restructuring: Crown Jewel Defence (Selling/Spinning off most attractive or valuable
part of the company to make one less attractive as a target)
 Legal (antitrust regulations to prevent takeover that may harm end users due to adverse
pricing or insufficient participants)
 Pac Man Defence (makes for a counter bid on acquirer if both are of similar size)
Supermajority provision under charter amendments: usually 50% is enough but now 70% of
shareholders have to agree
Staggered board terms: Only can change a certain no
...

Flip in provision to allow existing shareholders, apart from acquirer, to buy shares at a
discount to dilute acquirer’s holding
Flip-over allows all existing shareholders to buy shares so hostile acquirer buys shares at
high extra cost to maintain % ownership
Taking on unsustainable levels of debt
Undesirable acquisitions that add significant cost to new prospective acquirers
Something that is very painful if it happens
Cancellation of key supply contracts
Golden parachute: If you fire current CEO, compensation fee is high
Unfunded pension liabilities

Crown Jewel Defence is to sell the valuable asset of the company and usually used as a threat
(last thing you want to do)
Standstill agreements: Dictates that the suitor holds off for a certain period which are usually
imposed by regulators
...

White Knight arrangement: Not an acquisition defence at all since the target company is
eventually still acquired, just by a more amenable acquirer
...

Tender offer is a situation where the hostile acquirer bypasses management and goes straight
to shareholders
...

Only poison pills and staggered boards are adopted by majority of firms and increase
shareholder wealth
...
They are also chosen due to flexibility in counteracting takeover threats, credibility
and predictability in outcome
...
In
Peoplesoft’s defence against Oracle, the target required an acquirer to fully refund the
customers if technical support is ceased
...
Every company tends to have some unfunded pension liability and some companies use the
acceleration of maturity date of pension liability as poison pill upon qualifying action such as
outright change in ownership
...


Joven Liew Jia Wen
MSIN3004 M&V Notes
However, poison pills are actively destructive to corporation’s well-being and represent a stark
contradiction to top management’s mandate to maximize shareholder value
...

Other ATDs require more lengthy regulatory approval such as dual class capitalizations
...
Improved bargaining power associated with poison pills led to
higher takeover premiums
...
They are less flexible because they are set in stone by
earlier shareholder votes
...
Need to wait for AGM
...

Hostile vs friendly takeovers: Hostile acquisitions are like Barbarians at the Gate while Friendly
takeovers may have high APP and overpayment
...
It provided retail investors
some rational for resistance and bought some time
...

Best tactic for hostile acquirer to close the deal: Top price, preferably all or mostly in cash
...


Lloyds takeover of HBOS
Lloyds Banking Group’s state-sponsored takeover of HBOS
Different definitions of profit on the annual results of Lloyds Banking Group
Pre-tax profit that excludes cash restructuring cost that is part of firm’s core business and
includes non-cash fair value boost that is not part of core earnings
However, Lloyds is still the bank with the largest single shortfall between loans and deposits in
the world and more dependent on public funds in absolute terms
...
7 billion pounds for a bank with book value of 17
...

But this is computed based on Lloyds share price when the deal is closed by the point the share
price has collapsed as investors discounted the gory consequences of the takeover
...
Should have included the giant losses it was clear HBOS would
make 6 months after the acquisition
...


Joven Liew Jia Wen
MSIN3004 M&V Notes
Activists discourage companies from investing in their businesses, citing wasteful spending
...
Corporations targeted by activists boosted dividends and stock
repurchases
...

However, some investors aren’t happy because the automaker should keep the cash to protect
against uncertainties or downturn
...
However, continued cost-cutting
efforts may hamper Juniper’s ability to keep pace with innovation in the industry
...
Hence, we need an
objective valuation approach
...
They just assume
Net income = Share price without proof
...
82% below those non-acquired units
Luo (2006) found that only 36% of acquirers perform positive abnormal returns, showing
obvious wealth loss after M&A
...
By working together, their products
are introduced more quickly into new markets

Get skills/technologies faster or lower cost than building in-house



Cisco systems used acquisitions to close gaps in its technologies
It assembled a broad line of networking products and grow into a key player of Internet
equipment

Pick winners early and help them to develop their business







Making acquisitions early in the lifecycle of a new industry long before others recognize that
it will grow significantly
Johnson and Johnson bought device manufacturer Cordis and orthopedic-device
manufacturer DePuy in medical device business
Must be willing to make investments early before competitors
Able to see industry’s potential
Need to make multiple bets and expect some to fail
Need the skills and patience to nurture acquired business

Roll up strategies consolidate highly fragmented markets where current competitors are too
small to achieve scale economies
...

Transformational merger required the redefinition of company’s mission, strategy, portfolio, key
processes from research to sales
...
Switzerland Novartis which shifted its focus to innovation
in life sciences businesses and implemented performance-based system
Another way to create value is buy cheap at a price below company’s intrinsic value (but rare
since there is APP involved
...
2 oil and gas investment by BP in 2011
When Strategic deal means a money-losing game
Initially, it looks good since BP has a 30% stake in a natural gas block and it is the first oil major
to gain a foothold in one of the world’s most energy-hungry emerging markets
...
Delays in permission for future investment plans
BP may have overpaid as it rushed to gain momentum after the Gulf of Mexico difficulties
But BP insists it is a multi-decade deal and financial community overlooked this and the rest of
the oil and gas blocks it picked up
...

Production from the main KG basin has fallen and downward trend likely to continue
The field’s third partner, Niko Resources, cuts its reserve estimate by 80%
...

Furthermore, India’s bureaucracy is sluggish with weak political leadership and high profile anticorruption drives that delay approvals of a series of much-needed capital expenditures
...

Ambani lost his regulatory touch since bureaucrats do not want to be accused of doing favours
for India’s richest industrialist
...

British Airways learnt that bolting on an airline with different operating philosophy and cost
structure often fails
Citigroup also learnt that a successful consumer bank need to mean a successful
investment bank
Unum Insurance and Provident Insurance
Equal-to-equal combination is offset by chaos in PMI
...
To view a
foreign market as appealing may be due to incomplete investigation of overseas target
...

Phase timing in merger wave: Late phase deals increase prospect of merger value destruction
as eager acquirers overestimate synergies
...
Acquirer pursue targets in segments well-known to
buyer esp when target is cash-strapped
...

 Operational: Bolt-ons
...

Usually involves same sales territories, target customers or channels
...

 Transitional: Consolidations that involves companies that are already well-established
...
Combining R&D efforts and investment budgets
...
CEO motivated to steer company in a dramatic
new direction
...

Consolidation type acquisitions exhibit higher success rates
...

Bottom trawlers actively seek companies in distress that declared they can no longer compete
...
of bidders and bid cycles are minimal so
APP is small or even zero (87 to 92% success rate)
Projected synergies decline with delays to sale date since e-synergies decline further as
company growth stagnates
...
Risks are minimal
...
Tropicana
expanded footprint indirectly reduces space available for competing products and multiplies
PepsiCo’s selling space (80 to 85% success rate)
Line extension equivalents to increase scale economies but have to be careful that there may
be potential damage to respective commercial franchises and lose traditional accounts or
reputation

Joven Liew Jia Wen
MSIN3004 M&V Notes
Consolidation mature: sector profit growth rate has flattened and survivors’ strategy has become
defensive
...

Multiple core related complementary: P&G acquiring Gillette
Consolidation emerging: combining with rival with objective of emerging as one giant in a sector
presently populated with midgets but business models of emerging industries are unstable and
entrepreneurs may be good at starting companies but not building them into major, consistently
profitable corporations
Single core related complementary: target business only has one connection to acquirer’s base
business thus limited synergy opportunities
Lynchpin strategic: capture a supplemental core business to elude implosion and business of
target is largely unknown
Speculative strategic: minimal success that was driven by desperation or ego
*Adjust profile success % based on timing, relative size, relative APP and geography
When target’s HQ is nearer to acquirer’s HQ, it is easier to diagnose candidate synergies and
monitor operations
...
There can be conflicting business models and
ownership structure and cultures
...
Event Studies (observation of changes in share price: acquirer share price usually falls
...
TSR (require company to be bought and sold)
3
...
IVE (Valuation based on discounted cash flow basis of acquirer and target and the
combined company with APP)
Anticipatory purchase premium is included in the market price due to market speculation
...
It is risky for trade acquirers to carry out LBO as overloading the company
with debt can increase risk of bankruptcy and instability
...
Zell and Chicago Tribune
...
Deal architect may blame on poor PMI or unforeseen market
conditions deterioration
...
Bruner
argued that all M&A are local and individual company metrics prevails which can be altered
or revenue based
...
Ex
...
Incomplete and incorrect MV criteria blur clarity
of merger performance
...

Coley & Reiton shows that if you choose to acquire a small instead of large company, there is
24% improvement in merger success because small companies are easier to understand and
better to integrate
...

Transition from unrelated to related company increases merger success by 7% since you know
the operations better and both companies have similar business models
...
Beer
company buys a beer company is better than beer company buys the mill
...

Timing in merger cycle: During 1st phase, APP is only 10 to 18%, less chances of overpayment
1st merger wave: Hostile takeovers, LBO
2nd merger wave: Friendly takeovers, Dot com I
3rd merger wave: Subprime, relaxation of cash, Universal banking concept
4th merger wave: Dot com II
Operational mergers: Target is complement to existing operations

Joven Liew Jia Wen
MSIN3004 M&V Notes
Transitional and strategic mergers: Target contributes to profits in this cycle, major source of
value in the next
...
FB buying Instagram
Metamorphosis: Seeking business model transition such as IBM buying PWC
...
Disney and ABC (success rate is 40-45%)
Lynchpin Strategic: Support major change in emphasis in acquirer’s strategy ex
...
AOL/TimeWarner
(success rate 15-20%)
Unless documented merger failure approaches 100%, deals will continue
...

Ostrich effect: Top management learning from merger failures is mixed

Tutorial: AbbVie/Pharmacyclics Winner’s remorse
EXAM QNS: On what basis might it be said that an acquirer is simultaneously both successful
and a failure on the same transaction?
Based on transactional basis, success is measured when the deal is closed
...
However, this is ambiguous and it is not aligned with the interests of
the continuing shareholders of the acquiring company
...
This is aligned with the interest of the continuing shareholders of the
acquiring company since they are the one to put up the risk capital
...

Historically, Winner’s remorse (WR) refers to the post-closing regret expressed by acquiring
company CEO or his successor regarding a specific transaction based on post-announcement
sharp decline in acquirer’s share price which never reverses, persistent losses, crushing debt
burden or loss of key accounts and acquired unit buried
...


Joven Liew Jia Wen
MSIN3004 M&V Notes
Since admitting to a bad major deal is tantamount to CEO handling in his resignation, exceeding
few CEO admitted their mistakes
...

HP/Autonomy was acknowledged by Whitman, successor to Apotheker
...
5 billion
Quaker Oats/Snapple  30% fall
Daimler-Benz/Chrysler  70% write down
Microsoft/Nokia  90% write down
HP/Palm  2 billion to 1 pound
Terra Firma/EMI  10 billion to 1 pound
Sometimes to elude sacking, CEO usually gives excuses like emergency action necessary to
change firm’s prospects, target is good quality and bidding is separate, part of a grander
strategy and financial market is blind to the longer term benefits of the deal
...

WR is an immediate regret diagnosed by market-influencing evaluators specific transaction
based on VG
...
Every deal now becomes subject of informed analysis
even before they close
...
AbbVie paid a 50%
premium over Pharmacyclic’s share price just weeks earlier
...

 APP was pushed out of justifiable range by acquisition chase with J&J
...
Did not use conservative analysis and did not tolerate winning by
walking away
...
There is only a 10%
possibility that the sector explodes in volume and past margins on these compounds are
maintained
...

 Pharma is arguably the most overheated in a white-hot global M&A market
...

 Furthermore, AbbVie has always been a chronic overpayer relative to NRS
...

Some argue that the high rates of divestitures are evidence of the failure of past acquisition
programs
...

Such transactions increase mobility of economic resources
...

Many companies have tried to take advantage of strengths in their existing product market to
combine with capabilities in new product areas
...
ITT was broken up
...

 Abandoning core business: Sale of core business due to changing circumstances
...

 Changing strategies or restructuring: IBM sold Rolm’s manufacturing operations to Siemens
to form a joint venture on switchboard business
 Adding Value by Selling to a Better Fit: IBM sold most of its US copier business to Eastman
Kodak
 Large additional investment required: Divestiture to focus on other major business areas
 Harvesting past successes
 Discarding unwanted business from prior acquisition
 Financing prior acquisition to pay off bank debt
 Warding off takeovers: Divestitures have functioned as a takeover defense by removing the
crown jewel that attracted the takeover threat
 Meeting government requirements to gain approval for merger
 Selling businesses to managers
 Taking a position in another firm: Divestitures may be used to finance an investment in
another firm
 Reversing Mistakes
 Learning: Successful companies may divest business after learning more about them
Most companies have divested many more acquisitions than they had kept
...

When acquisitions were in fields unrelated to company’s existing field, rate of divestiture is 74%
...
A billion dollar transaction is
given no more weight than the sale of a million dollar asset
...

Most companies achieved below-average stockholder returns
...
Size of stock price effect is positive and increasing function of percentage of

Joven Liew Jia Wen
MSIN3004 M&V Notes
firm divested
...
5%
...

This can be market’s positive response to the correction of previous mistakes
...
White
knights on average pay too much for targets they acquire
...

Eventually, divestiture/acquisition ratios do not provide unambiguous evidence on success or
failure of corporate strategies
...
Acquirer returns
and total returns at the acquisition announcement are lower for unsuccessful divestitures than
for successful divestitures and acquisitions not divested
...

Porter finds that over 50% of the acquisitions made in new or unrelated industries are later
divested
...

Weston argues that acquires sell targets for a number of reasons which do not involve poor
performance
...

Some acquisitions that led to efficient allocation of resources may no longer be efficient
...

Firms have tendency to understate and disguise mistakes they have made
...

Authors do not have reasons for all divestitures made
...
Acquirers overpaid for divested acquisitions and firms would have done better if
they had invested the money in the S&P 500
...

Overall divestiture rate is 43
...

High divestiture rate is consistent with the view that acquisitions are mistakes and do not
increase value
...
Followed by finance
subsequent acquisitions then antitrust, needing cash, defending against a takeover and
receiving a good price
Using accounting data, net book value is used
...

Results are generated entirely from one period (during 1970s and early 1980s)
Announcement period returns to acquirers in mergers are significantly more negative for
acquisitions financed with stock than cash
...

Unsuccessful acquisitions tend to be divested after the CEO that made the acquisition leaves
the firm
...


Clark & Mills: Chapt 8 Seven Keys to Merger Success
Keys of Success
1 Following the right merger success criteria

Description
Main criteria setters: continuing
shareholders of the acquiring company
since they provide the risk capital for the
transaction
...
Use Value Gap (VG) or
Incremental Value Effect (IVE)
...

TSR limitation: does not include successful
acquisitions that are not disposed off
...
People still fear of the recession
but plentiful of quality targets and only
acquirers with excess cash are acquiring
...

Late 3rd and 4th phases exaggerate the

Joven Liew Jia Wen
MSIN3004 M&V Notes
threats to merger success from diminishing
supply of quality targets, extremely high
APP and collapse of inflows at worst
possible time
...
Acquirers
need to know where to look and avoid
...
Bolt-ons and bottom trawlers are
preferred as compared to strategic
transformational M&A
...


4 Adhering to absolute and relative limits on
APP

At the very least, APP should not be higher
than 38%
...

Most of the time, anticipatory purchase
premium may be included in the target’s
share price
...
Do not be involved in
bid chase
...


5 Bid pricing integrated with in depth 4 types of
synergy PMI investigation

The bid process should be informed by the
Net Realisable synergies involved to
prevent overpayment
...

NRS look at present value of synergies that
are adjusted for offsets and timing of
implementation
...

Careful separation of real from illusory
synergies in expense, revenue, financial
and management areas
...

Look at simple void fills and product line for

Joven Liew Jia Wen
MSIN3004 M&V Notes
r-synergies and outright terminations for esynergies
...

Management synergies are taken to be zero
since every acquiring management thinks
that they are superior
...

Mergers accelerate the decline of firms
approaching irreversible decline than saving
them
...

Desperate acquirers contribute to buyers’
panics
...


Last man standing: Some valuable companies that have missed out on industry’s primary
merger movement esp when there is consolidation in mature industries
...

Winning by walking away: Do not proceed further with acquisition chase and walk away from a
potentially value destructive merger due to overpayment
...
In AOL/Huff Post, Arianna
Huffington did the right thing by selling Huff Post at an outrageous APP
...
The dividend group (Olsen)
just did a tautology and assume that dividends are exactly correlated with share price
...
This was a weak assumption in response to the 0
...

Two and Twenty: Private Equity Concept
...

Viability threshold: CFROI = WACC
...

For a short while, it is still okay
...
It is the concept of market rationalization
...

If SSME holds, then MICAP shows that share price increases, cash flow increases
...

ODCAP says that stock price is unreliable
...

MVE = Market Value of Equity = Market Capitalisation (MC) – Market Value of Debt (MVD)
TAPP = Total Acquisition Purchase Premium: Amount I pay over the company’s share price
...
Use the
share price of the company before announcement
...
Horizontal merger is the
acquisition of a closely related company
...
Beer company buying a beer company
...
Fords and GM
...
Vertical merger can be unrelated
companies with different business models
...

Terminal Value (TV) and Company Value (CV) of high tech and skincare companies





CV = EPP + TVP from DCF2S
For high tech companies, there are huge investment outlays in the earlier period
...
Hence, EPP value is negative
...
Cannot disregard
timing and the criteria of merger valuation
...

Winning by Walking Away: You are better off not doing the deal
...
Barclays is lucky it
did not buy ABN Amro
...

GCBP: Good Company Bad Price
...
It is attractive
because it is a well run company
...
AOL still went ahead to buy Huff Post at an extremely high
APP resulting in GCBP and overpayment
...

Last man standing: Merger segmentation
...
Nervous since it may become a small scale player in a vulnerable
position
...
These companies may not want to be left out and do some
desperate acquisition
...
Target is paying activist or potential acquirer to
go away
...
Paying the unwanted acquirer but this is temporary and
there is no value creation
...
Late phases of merger
cycle where it is a seller’s market
...
Huff Post is sold at a high price and
the CEO did not become a vanquished seller
...

Foundations of fake (table 6
...

Can say anything since no name on the paper
...
Ex
...

Secondary valuation argument: Value of FB shot up from 50 bn to 90bn just to increase the
resale valuation so that people who bought the shares earlier would make a profit
...

Clear day: Anti-Takeover Defence which is less likely to be overturned since it is implemented
way in advance
...
However, target share price increases too
...

Liu talked about multiples, William came about the Gordon Formula first
...
Mens Warehouse bought a sports attire company to make itself more
expensive but it is an ineffective tactic since business models don’t fit
...
Out of sync
...

Defence of acquisition is a hurried rush of acquisition of an unattractive company to make my
acquirer not to acquire me
...
Ebay spinning off PayPal
Kaplan and Weisbach identify earlier versions of ES to argue that most mergers succeed
but this was based on truncated and very brief truncated periods
According to K&W, only 35 to 50% of divestment studies occur due to deal failures
Diversifying (non-related) acquisitions are 4 times more likely to be divested
...
IBM sale of ThinkPad to Lenovo
Cancel conglomerate discount
Inability to finance the SBU’s future growth: Division is attractive but future prospective cash
requirements are so great
...

Harvest past success: Most profitable way to cash in the internally developed unit is to
attract a buyer to pay above the full value of the unit
...


M&A A to Z
A for APP
APP is part of VG and IVE
...
APP is the amount of necessary overpayment above the
day-to-day share price required for the acquirer to secure control and ownership of target
company
...
Azofra-AMS studies show that max APP
is 38%
...
Being drawn into a bidding war is a near-assured way
for would-be acquirers to have an instant failure deal due to overpayment in excess of NRS
...

C for cash
A high percentage of the early phase deals of merger cycle are for cash only
...


Joven Liew Jia Wen
MSIN3004 M&V Notes
D for Day One Pop
Pop is the upward variation in the newly launched company’s IPO price during the initial trading
session
...

E for Mergers of Equal
Zero premium mergers of giants of the same sector
...
The scope of new combined firm, internal fighting between the
two management, slow decision making and clash of corporate cultures make it difficult to
succeed
...

G is for GCBP
G is for Good company Bad price
...

H is for Hewkett-Packard
HP is the worst ongoing acquirer as evidenced by a series of regrettable deals
...

However, many have been stopped by the US government
...

J for Johnson & Johnson’s role in Pharmacyclics 2015 deal
J stands for Johnson & Johnson’s whose participation in the chase for Pharmacyclics helped to
drive the price up to a value-destructive level, causing a value-diminishing acquisition by the
eventual ‘winner’ AbbVie
...
Merger success can mean different things to different
participants in the deal process
...
It exploits a company’s under leverage in order to buy the company under its
own balance sheet
...

N for Net Realisable Synergies
NRS is synergies that are calculated based on incremental cash flow basis and take into
consideration full offsets and timing issues
...
Delay in the implementation of PMI will
reduce Present Value of synergies
...

P for Pharma
Pharmaceutical is the hottest and most overdone M&A sector and it is a possible advance
indicator of the merger wave’s eventual decline and demise
...
These
reasons provide an excuse for the regrettable deals
...
Common errors of rsynergies include failure to measure cash flow effect instead of mere increase in sales
...

T for Transformational deals
Transformational deals mean that the deal will not make money and refer to the low success
prospects for Lynchpin Strategic or Speculative Strategic deals
...


Joven Liew Jia Wen
MSIN3004 M&V Notes
U for Unum-Provident
The failed deal showed that it is not true that companies in the same industry may be always
compatible
...
Different business models and consumer base
...
They assume to cut down from 26 to 6
IT platforms but it is impossible
...
However, acquirer may have limited understanding of target’s business
model
...

W for Winner’s Remorse
Regret that the CEO of acquiring company feels as value-destructive deal looms
...
Dangers of Dot com II companies
evaluation that are based on silver extrapolation

---