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Business Valuation: Understanding the Value of Private and Public Companies

McDevitt & Kline SeminarSeptember 2016

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About Your Speaker

HomeIndustryToday

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Objectives for TodayUnderstanding private company valuations• Asset-based• Income-based• Market-based

Understanding publiccompany valuations• Intrinsic value vs.

standalone value

Understanding private company valuations

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A Little Background

Extremely low valuations

Extremely high valuations

The old days Current Standards

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A Little BackgroundInternal Revenue Service• ARM 34 Intangible Value• RR 59-60 Valuing Closely held Stock• RR 68-609 Formula Method• RR 93-12 Allowance of Minority Interest Discount in

Family Owned Business

United States Department of Labor• Employee Stock

Ownership Plans

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A Little BackgroundWhy?• Baby boomers are wealthiest generation,

retiring with major assets.• Litigation• Tax planning• Financial reporting

changes

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A Little BackgroundPurposes of Valuation• Mergers and acquisitions• Sales and divestitures• Estates!• Buy/sell agreements• Bankruptcy• Loan applications• IRC §338 Purchase

price allocations

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A Few Dimensions…

StrategicValue

Fair Value

BookValue

Going Concern

Value

LiquidationValue

Replacement Value

Tax

StandardsOf

Value

PremiseOf

Value

ClassificationsOf

Value

Fair Market Value

Fair Market Value

Going Concern

Value

Non-TaxNon-Tax

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Three Standards of Value1. Fair Market Value: price at which a

property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the facts.

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Three Standards of Value2. Fair Value: price that would be received

for an asset or paid to transfer a liability in a transaction between marketplace participants at the measurement date.

“My partners forced me out on 6/30/13.”

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Three Standards of Value3. Strategic/Investment Value: Value to a

particular investor based on individual investment requirements and expectations.

eBay purchase of Billpoint in 1999.

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Four Premises of Value1. Book Value: The difference between total

assets (net of accumulated depreciation, depletion and amortization) and total liabilities.

2. Going Concern Value:The value of a businessenterprise that is expected to continue, includingintangibles.

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3. Liquidation Value: The net amount that would be realized if the business is terminated and the assets are sold piecemeal.

4. Replacement Value:The current cost of a similar new property having the nearest equivalent utility to the property being valued.

Four Premises of Value

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Two Classifications of Value1. Tax: Estate; Gift; ESOPs; Charitable

Contributions.2. Non-Tax: Purchase; Sale; Merger; Buy-

sell agreements; Regulatory valuations

Appraisals for commercial purposes will frequently deal with factors of concern to prospective purchasers … as distinguished from a determination of IRS-acceptable value.

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Before we start….• What’s the standard of value (e.g. fair market

value)?• What’s the premise of value (e.g. going

concern)?• What’s the classification of value (e.g. tax)?

How will this valuation be used?• Is this for a controlling interest of the

company?• How marketable is this interest?• What’s the scope of the valuation

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Equity Interest as an Investment1. Alternatives: investors have alternatives, and

are not forced to proceed with any investment.

2. Substitution: value of an asset is determined by the cost of acquiring an equally desirablesubstitute.

3. Investment value: closely held businesses can be valued by comparing the projected benefit stream to a required rate of return.

4. Rate of return: higher risk investments require higher rates of return in order to be justified.

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Financial Statement AnalysisUnderstanding the firm - Major Approaches1. Common-size: helps to identify internal

trends and facilitates comparison to other firms.

2. Trend analysis3. Financial ratios4. Comparative analysis

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Financial Statement AnalysisCommon-size: This is not your father’s company!Gross profit margins in excess of 80%!?The highest level of SG&A I have ever seen.Outrageous net income margins and it doubles every year!?!?!Some restructuring activity.

(Values in Millions) Dec-04 Dec-03 Dec-02 Dec-01 Dec-00Sales 3,271.30 2,165.10 1,214.10 748.8 431.4Cost of Sales 420.8 307.7 153.2 81.7 51.7Gross Operating Profit 2,833.00 1,847.80 1,056.90 664.7 377.4Selling, General & Admin. Expense 1,514.20 1,029.60 626 434.6 295.7Other Taxes 17.5 9.6 4 2.4 2.3EBITDA 1,318.80 818.2 430.9 230.1 81.7Depreciation & Amortization 259.5 159 76.6 89.7 45.2EBIT 1,059.30 659.2 354.3 140.4 36.5Other Income, Net 77.9 37.8 49.2 41.6 46.3Total Income Avail for Interest Exp. 1,137.20 665.8 399.7 165.8 81.2Interest Expense 8.9 4.3 1.5 2.9 3.4Minority Interest 6.1 7.6 2.3 -7.5 -3.1Pre-tax Income 1,128.30 661.5 398.2 162.9 77.8Income Taxes 343.9 206.7 145.9 80 32.7

Special Income/Charges 0 -31.2 -3.8 -16.2 -1.6

Net Income from Cont. Operations 778.2 447.2 249.9 90.4 48.3Net Income from Discont. Opers. 0 0 0 0 0Net Income from Total Operations 778.2 447.2 249.9 90.4 48.3

Income Statement “Common Size” Statement

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Financial Statement Analysis

Income Statement “Common Size” Statement(Values in Millions) Dec-04 Dec-03 Dec-02 Dec-01 Dec-00Sales 193,517.00 185,524.00 186,763.00 177,260.00 184,632.00Cost of Sales 144,415.00 136,491.00 140,406.00 130,942.00 132,253.00Gross Operating Profit 49,102.00 49,033.00 46,357.00 46,318.00 52,379.00Selling, General & Admin. Expense 20,394.00 21,008.00 23,624.00 23,302.00 22,252.00Other Taxes 0 0 0 0 0EBITDA 28,708.00 28,025.00 22,733.00 23,016.00 30,127.00Depreciation & Amortization 15,536.00 15,580.00 12,938.00 12,908.00 13,411.00EBIT 13,172.00 12,445.00 9,795.00 10,108.00 16,716.00Other Income, Net 702 612 189 -149 -319Total Income Avai l for Interest Exp. 13,874.00 13,057.00 9,984.00 9,959.00 16,397.00Interest Expense 11,980.00 9,464.00 7,715.00 8,590.00 9,552.00Minority Interest 0 0 0 0 0Pre-tax Income 1,894.00 3,593.00 2,269.00 1,369.00 6,845.00Income Taxes -911 731 533 768 2,393.00

Special Income/Charges 0 0 0 0 0

Net Income from Cont. Operations 2,805.00 2,862.00 1,736.00 601 4,452.00Net Income from Discont. Opers. 0 960 0 0 0Net Income from Total Operations 2,805.00 3,822.00 1,736.00 601 4,452.00

Common-size analysis: This is your father’s company.Hardly any growth.Very thin staff.Same level of capitalization as previous slide (that’s weird).Earnings is staggering.

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Financial Statement AnalysisRatios: “LLAPS.”Liquidity: firms rich in cash or “near cash” that has much flexibilityLeverage: relies on debt and MUST generate current earnings.Activity: uses assets so well that it may not need high levels of profitability (“sells the same can of soup five times a week”).Profitability: sales that are generating a high level of profit given its sales and/or assets.Shareholders: the value accrued to shareholders.

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Financial Statement Analysis

Ability to pay ST obligationsCurrent Ratio

Ability to pay bills short term

Quick Ratio (acid test)Ability to pay off short-term obligations, except Inventory

Current AssetsCurrent Liabilities

Current Assets - InventoryCurrent Liabilities

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Financial Statement AnalysisAbility to meet LT obligationsDebt to Asset Ratio

Extent to which borrowed funds are used to buy assets

Debt to Equity RatioCompares funds provided by creditors to funds provided by owners

Total DebtTotal Assets

Total DebtShareholders’ Equity

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Financial Statement AnalysisManaging the use of assetsTotal Asset Turnover

Utilization of company assetsInventory Turnover

The number of times inventory was sold during a period of time

Average collection periodNumber of days to collect a sale (DSO)

Accounts Payable PeriodNumber of days to pay a bill

Days of CashNumber of days of cash on hand (given present sales level)

Net SalesTotal Assets

Net SalesInventory

Accounts ReceivableSales for Year 365

CashNet sales for Year 365

Accounts PayablePurchases for Year 365

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Financial Statement AnalysisReturn on Sales and AssetsProfit Margin (ROS)

After tax profits generated per each dollar of salesIt may be helpful to adjust for extraordinary items).

Return on Assets (ROA)Rate of return on assets utilized, a measure of management efficiency

Return on Equity (ROE)Rate of return on shareholders’ investment

Net ProfitNet Sales

Net ProfitTotal Assets

Net Profit Stockholders’ Equity

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Financial Statement AnalysisPrice Earnings (PE) Ratio

Stock price over current year or prior year EPS

Total Shareholder Return (TSR)

Dividends + share price at end of period (adjusted for splits)/share price at the beginning of the period.

Market Price per shareEarning per share

Dividends + Share price at end of periodShare price at beginning of period

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Financial Statement AnalysisNow We Look for “Comparables”1. Sources of benchmarks: Almanac of

Business & Industry Ratios; Risk Management Associates (RMA); D&B

2. Similar size, history, competitive position, line of business, capital structures.

3. RMA database has great benchmarks by industry (SIC).

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Analyzing Competitive Advantage and Profitability

• Measures of Profitability

capital investedprofitsnet

ROIC

capital investedrevenues

revenuesprofitsnet

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Drivers of Profitability (ROIC)

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Ways to Increase ROIC

Increase Company’s Return on Sales Increase sales revenue more than costs Reduce cost of goods soldReduce spending on SG&A

Sales, Marketing, General & Administrative Expenses Reduce R&D expenses

Research & Development

Increase Capital Turnover Reduce the amount of working capital

Inventory, Accounts Receivable, PayablesReduce the amount of fixed capital

PPE - Property, Plant & Equipment

Invested Capital / Sales!

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Comparing Wal-Mart to Target

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Normalizing Financial StatementsAdjust financial statements to more closely reflect its true economic financial position and results of operations on a current and historical basis.• Method of accounting (LIFO, FIFO, Wtd Avg)• Non-recurring transactions• Non-operating assets• GAAP compliance

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Normalizing Financial StatementsExamples:• Aggressive expensing to reduce income taxes• Excessive compensation, perquisites or rents• Controlling, or non-controlling interest

adjustments: if I am valuing a controlling stake, I should adjust executivecompensation to marketlevels; if I am valuing anon-controlling stake, Ishould not.

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Normalizing Financial StatementsSelected Checklist:• Allowances for doubtful accounts• Notes receivable• Inventory valuation• Depreciation methods• Adjust fixed assets to reflect

appreciation or impairment• Adjusting tax impacts such

as net operating loss carryforwards

• Intangibles!

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How Do We “Value” This?Criteria:• Controlling or non-controlling• Purpose: Mergers and acquisitions; buy/sell agreements;

bankruptcy; litigation• Method used: if we are using P:E then we better use net

income• Net cash flows vs. GAAP earnings: will GAAP earnings

approximate net cash flow in the future?

• Are other types of earnings (EBITDA) more relevant?

• Are we valuing just equity or allinvested capital?

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Commonly Used Methodsof Valuation• Asset-based Approach

- Book value method- Adjusted Net Asset Method

• Income Approach- Capitalization of Earnings/Cash Flow- Discounted Earnings/CashFlow

• Market Approach- Guideline Public Company- Comparable Private Transaction

Replacement?Liquidation?Going Concern?

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Income-Based Approaches

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Income-based Approach• Capitalization of earnings/cash flow

• Discounted earnings/cash flow

($ millions)

Free Cash Flow

Discounting Convention

Discount Factor

Present Value Cash Flow

Cumulative Present Value

Cash Flowt+2 497.47 0.50 1.06 470.07 470.07 t+3 1,110.77 1.50 1.19 937.13 1,407.19 t+4 1,191.51 2.50 1.33 897.54 2,304.73 t+5 1,233.22 3.50 1.49 829.43 3,134.16 t+6 1,275.90 4.50 1.67 766.19 3,900.35

Net earnings to equity $591,000Capitalization rate 21.32%Total (rounded) $2,772,000Value of non-operating assets $771,000Marketable controlling interest value $3,543,000

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Income-based ApproachControlling interest considerations• Can change capital structure• Can also remove excess salaries

and perquisites

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Income-based ApproachWhat’s a “terminal value”?• What the firm will be worth at the end of

the planning period, discounted back to present.

TV = CFn * (1 + g)k-g

CF = last year’s forecasted CFg = long-term sustainable growthk = cost of capital

Careful!

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The Future Benefit StreamNet Cash Flow to Equity:Net Income (after tax)+ Non-cash charges (e.g. depreciation)- Capital expenditures- Additions (deletions) to net working capital+ Changes to long-term debt from borrowing- Change to long-term debt from

repayments= Net cash flow to equity- Dividends paid to preferred= Net cash flow to common shares

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The Future Benefit StreamNet Cash Flow to Invested Capital:Net Income (after tax)+ Non-cash charges (e.g. depreciation)- Capital expenditures- Additions (deletions) to net working capital+ Interest expense net of tax benefit= Net cash flow to invested capital

Debt and equity holders have different required rates of return

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The Future Benefit StreamPurpose:• Historical economic income is

generally used for tax, buy-sell and divorce valuations because historical data is based on fact and hence considered more reliable.

• Projected income is usedfor litigation, ESOP’s, and transactional valuations

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The Future Benefit StreamMethods:Linear benefit stream• Unweighted average method =

sum of variables ÷ number of variables

• Weighted average method = ew1 + ew2 + eww1 + w2 + wn

Certain observations are more relevant

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The Future Benefit StreamMethods:Non-Linear benefit stream

• Projected free cash flows

• Projected earnings

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The Future Benefit StreamProjected free cash flowsPicks up growth oriented capital expenditure, debt payments, and shareholder payments($ millions) t+2 t+3 t+4 t+5 t+6

NOPAT $556.42 $1,152.85 $1,193.75 $1,235.59 $1,278.39Change in Working Capital $39.95 $43.08 $3.25 $3.36 $3.49Capital Expenditure $1,000.00L/T Debt $10.00 $12.00 $9.00Depreciation and Amortization $100.00 $100.00 $100.00 $100.00 $100.00Free Cash Flow -$393.53 $1,209.77 $1,290.51 $1,332.22 $1,374.90

Present Value Cash Flow -$371.85 $1,020.65 $972.11 $896.01 $825.64Cumulative Present Value Cash Flow -$371.85 $648.80 $1,620.91 $2,516.93 $3,342.56Terminal Value $3,496.66Net Present Value $6,839.23

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The Future Benefit StreamProjected free cash flowsStatic Trend Line Method: Take the average value of a fitted regression line. Pulls in “outliers”.

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Capitalization/Discount RatesComposed of two parts:1. A safe or reasonable return on a secure

investment.2. An additional return (premium) that

compensates the investor for relative degree of risk, in excess of the safe rate, inherent in the investment.

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Capitalization/Discount RatesWhat kind of risks?1. External: economy; industry risks.2. Internal: Company-specific expectations;

Financial condition of the firm; Size of the firm; Quality and depth of management and staffing

3. Investment: Is businessdiversified? How liquidis the investment?

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Capitalization/Discount Rates1. Discount rate: A rate of return that

converts a series of future income amounts into present value.

2. Capitalization rate: A divisor (or multiplier) used to convert a definedstream of income to a present indicated value.- linear w/ no growth- linear but constant growth

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Ibbotson Build-Up MethodKe = Rf + ERP + IRPi + SP + SCR, where:• Ke = cost of equity• Rf = risk free rate of return• ERP = expected equity risk premium (equity

in excess of free rate)• IRPi = expected industry risk premium for

industry i (if appropriate)• SP = size premium• SCR = specific company risk

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Capitalization/Discount RatesIbbotson - rationale1. Equity risk: consistent long-term premium

between S&P 500 and Treasury securities.2. Industry risk: Five forces model!3. Size risk: Over time, smaller firms have

significant and consistently exceeded returns on larger firms.

4. Company specific risk:Age, market dominance,financials.

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Ibbotson Build-Up Method

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Ibbotson Build-Up MethodData sources:• Rf = 20 year yield to maturity on t-bills• ERP = Long-term equity premium from

SBBI Yearbook• IRPi = SBBI Yearbook• SP = SBBI Yearbook• SCR = subjective assessment

of company-specific risks

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Ibbotson Build-Up MethodWhat about debt plus equity investors?A weighted average cost of capitalWACC = (ke x We) + (Kd/(pt) [1-t] x Wd), where• WACC = weighted average cost of capital• ke = Cost of common equity capital• We = % of common equity• Kd/(pt) = Cost of debt capital

pre-tax• t = Tax rate• Wd = Percentage of debt at

market value

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What should be the WACC?

WACC

If using Investment

Value Standard, then use buyer’s desired capital

structure.

If Fair Market Value is used,

then use industry average

capital structure.

Cannot change the capital structure.

Remains intact.

Controlling interest

Non-controlling

interest

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Other Build-Up Methods• Schilt’s Risk Premium Guidelines• Risk Rate Component Model

(RRCM)• Jeff Jones Method• Black/Green Build-up• Value-Netex

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Capitalization/Discount RatesRisk-Rate Component Model (RRCM)Four general categories of risk:1. Competition2. Financial Strength3. Management Ability & Depth4. Profitability & Stability

of Earnings

Ratio analysis, questionnaires

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Capitalization/Discount RatesRisk Factor (by General Category):Competition 6.44 Financial Strength 4.00 Management Ability & Depth 5.33 Profiability and Stability of Earnings 4.00 Weighted Average Risk Factor Premium 19.77

Calculation of Capitalization RateTotal weighted average risk premium 19.77 Assume safe rate of return (Standard & Poors) 4.80 Natoinal economic premium (or discount) 2.00 Local economic premium (or discount) 2.00 Indicated pre-tax capitalization rate (rounded) 28.57

Competition Risk Index WeightProprietary content 8.00 1.00 8.00 Relative size of company 8.00 1.00 8.00 Relative products/service quality 4.00 1.00 4.00 Product/service differentiation 6.00 1.00 6.00 Market strength 8.00 1.00 8.00 Market size and share 8.00 1.00 8.00 Pricing competition 6.00 1.00 6.00 Ease of market entry 2.00 1.00 2.00 Patent/copyright protection 8.00 1.00 8.00 Other considerations - - - Competition weighted average 9.00 6.44

Risk-Rate Component Model (RRCM)

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Asset-based Approaches

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Asset-based Approach• Book value: assets – liabilities; seriously

flawed.• Adjusted net asset value: adjust assets to fair

market value.Remove non-operating assetsLIFO to FIFOReal estate appraisalRemove excess cash

• Ideal for real-estate holdingcompanies or when the valueof the firm is based on the valueof the assets.

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AdjustingAssets For the Year Ended June 30: (in 000's) 2006 Adjustments

2006 Re-Cast

AssetsCurrent Assets

Cash 1,403 (679) (1) 724Accounts Receivable (WIP) 891 891Inventory 49 5 (2) 54

Other Currrent AssetsLoans to Stockholders 0 0Short-term Investments 2,150 (2,150) (3) 0

Total Current Assets 4,493 (2,824) 1,669

Fixed AssetsProperty, Plant & Equipment 900 433 (4) 1,333Land 900 (900) (5) 0Other Fixed Assets 25 25

Total Fixed Assets 1,825 (467) 1,358

Other AssetsDeposits 150 150Other 0 0

Total Other Assets 150 0 150

Total Assets 6,468 (3,291) 3,177

Adjustment notes:

(4) Increase total fixed assets to current market value of $1.36 million.(5) Remove value of land that is not supporting operations.

SWIFTCO CONSTRUCTION, INC. Re-Cast Balance Sheet Summary

(1) & (3) In order to reduce cash and equivalents from 54.9% of total assets to the peer average of 11.2% of total assets, $2.8 million of cash and marketable securities must be removed from the balance sheet. $2.15 million was removed from marketable securities. The remaining $679 thousand was removed from cash.(2) Adjusting inventory value from a FIFO basis of $49 thousand to a LIFO basis of $54 thousand.

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AdjustingLiabilities &Equity

For the Year Ended June 30: (in 000's) 2006 Adjustments2006 Re-

Cast

Liabilities & EquityCurrent Liabilities

Notes Payable (Short-term) 135 135Accounts Payable 10 10Other Current Liabilities 3 3

Total Current Liabilities 148 0 148

Long-term LiabilitiesNotes Payable 1,831 1,831Other Long-term Liabilities 0 0

Total Long-term Liabilities 1,831 0 1,831

Stockholder's EquityCommon Stock 55 55Paid-in Capital 465 465Retained Earnings 3,969 (3,291) 678

Other EquityDividends 0 0

Total Other Equity 0 0 0

Total Stockholder's Equity 4,489 (3,291) 1,198

Total Liabilities & Equity 6,468 (3,291) 3,177

SWIFTCO CONSTRUCTION, INC. Re-Cast Balance Sheet Summary

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Market-based Approaches

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Market-based Approach• Advantages

- User-friendly- Based on real data- Easy to apply- Does not rely on explicit forecasts

• Disadvantages- Lack of comparables- Standard of value unclear- Important assumptions“hidden”

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Market-based ApproachCommon Market Multiples• Price/Earnings• Price/Cash Flow• Price/Revenue• Dividend/Price• Price/Book value• Earnings per Share

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Market-based Approach• Private Transaction Sources

- Institute of Business Appraisers- BIZCOMPS- Pratt’s Stats- DoneDeals

• Public Transaction Sources- Alacra- Compustat- Reuters- Mergent

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Market-based ApproachMatch your multiple to the right parameter• Total Invested Capital paired with

- Revenues- EBITDA- EBIT- Debt-free net income- Debt-free cash flows

• Equity paired with- Pretax income- Net income- Cash flow- Book value of equity

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Market-based ApproachExamples: Excess Earnings/Treasury Method1. Estimate future earnings of company without growth.2. Determine GAAP net assets (exclude goodwill or other

intangibles) at fair market value.3. Select reasonable rate of return on equity(2).4. Multiply net assets (2) by ROE (3)5. That product is the net income attributable

to tangible assets. Subtract that from (1). Difference is income from intangibles.

6. Divide residual income (5) by reasonable capitalization rate for intangible assets.

7. Add GAAP tangible net assets (2) and intangible assets (6).

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Market-based ApproachExamples: Excess Earnings/Treasury Method1. 5 year weighted average historical after tax

economic earnings are $250,000.2. GAAP weighted average net assets net of

intangibles are $980,000.3. The value of adjusted net assets are $1,050,000.4. Industry average ROE is 12%.5. The appropriate after-tax intangible

capitalization rate is 29.69%.

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Market-based ApproachExamples: Excess Earnings/Treasury MethodCalculate value of intangiblesWeighted average historical after-tax earnings $250,000Less earnings attributable to tangible assets:

GAAP net assets (weighted average) $980,000x Industry ROE (weighted average) 0.12 -$117,600

Excess earnings attributable to intangible assets $132,400Divided by intangible capitalization rate 0.2969

Estimated value of intangibles (rounded) $446,000

Determine the value of the entire businessValue of intangibles $446,000Value of net adjusted assets $1,050,000

TOTAL VALUE OF BUSINESS $1,496,000

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Market-based ApproachExamples: Excess Earnings/Reasonable Rate MethodThe same as “Treasury” method, except…1. Uses a “reasonable” rate to capitalize adjusted

net assets.2. Uses latest year’s net asset balance,

not a weighted average of history.3. Uses pre-tax economic earnings,

not after-tax.

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Market-based ApproachHow do we value intangibles?1. Arms-length bargaining: a purchase agreement

may be given weight if arms-length and parties have competing financial interests.

2. Residual value: after deducting tangible assets and identifiable intangibles frompurchase price.

3. Earnings-based (what we just covered)

4. Royalty-avoidance: what would it cost to purchase it from anotheroutsider?

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Discounts & Premiums

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Valuation Discounts & PremiumsThe big two:1. Control: will investor have control over the

firm? - Set policy- Appoint management- Power to acquire and dispose of assets- Dictate dividend policy- Establish buy/sell agreements- Reorganize- Block all of the above

2. Marketability: how easily can this investor sell this investment?

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Valuation Discounts & PremiumsSome others:1. Market absorption2. Key person/thin management3. Lack of diversification4. Small company risk5. Specific company risk

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Valuation Discounts & PremiumsLevels of value:1. Synergistic value (more later)2. Controlling interest value3. Marketable minority

interest value4. Non-marketable

minority interest value

Synergisticpremium

Discount for lack of control

Synergisticpremium

Discount for lack of marketability

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Valuation Discounts & PremiumsConsiderations:1. Representation on Board of Directors2. Contractual Restrictions3. Shareholder Agreements4. Industry Regulations5. State Law & Statutes6. Voting Rights7. Concentration of Ownership

(2% ownership w/ two49% owners = less discount)

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Valuation Discounts & PremiumsRanges of Control:CONTROLLING100% Equity Ownership PositionControl Interest with Liquidating Position51% Operating ControlTwo Equity Holders, each with 50%Minority with largest blockMinority with “swing vote”Minority with “cumulative voting” rightsPure minority interest – no control LACK OF CONTROL

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Valuation Discounts & PremiumsSources of Empirical Data - Control:1. Mergerstat Review2. HLHZ Control Premium Study3. SEC Studies4. Morningstar Principia

Changes in share price due toacquisition.

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Valuation Discounts & PremiumsDiscounts for Lack of Marketability:1. Uncertain time horizon to complete the sale2. Cost to prepare for and execute the sale3. Risk as to eventual sale price4. Non-cash and deferred

transaction proceeds5. Inability to borrow against

the estimated value of the firm

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Valuation Discounts & PremiumsDiscount for Lack of Marketability (DLOM):Increases:1. Restrictions on transfers2. Little or no dividends 3. Little or no prospect of public offering or sale, especially

if stated in corporate documentation4. Limited access to financial informationDecreases:1. “Put” options2. Market available that may be interested in purchase3. Imminent public offering or sale4. High dividends

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Valuation Discounts & PremiumsQuantifying the DLOM:• Restricted stock studies - Comparing private

placements of restricted shares. These restrictions are generally imposed by the SEC.

• Compare pre-IPO prices topost-IPO prices

• Look at publicly traded P/E ratios to private purchase P/E’s

• Measure flotation costs and subtract from purchase price

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Completed Transaction and Guideline Public Comparable Methods

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Comparable TransactionsIn the same way that we estimate real estate values by observing sale prices of comparable properties, we can observe the transaction prices of comparable firms to estimate the value of the subject firm.

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Guideline TransactionTricky … transactions differ• What assets and liabilities are included?• Non-compete and employment

agreements• Restricted stock? Below market

financing?• Earnouts?

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Guideline TransactionAvailable Data• Public company sales• Private company sales to public

companies• Private company sales to private buyers• Private databases, such as

Pratt’s StatsTM; specializein different deal sizes.

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Guideline TransactionEquity• Price/Revenue• Price/Earnings• Price/Equity

Cash Flow• Price/Book value• Price/Dividends

MVIC• MVIC/Sales• MVIC/EBITDA• MVIC/EBIT• MVIC/TBVIC

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Guideline TransactionMultiples for small companies• Discretionary Earnings• Gross revenueMultiples for large companies• MVIC/EBITDA

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Guideline Public Company MethodBasic Procedure• Locate comparable firms with as many similar

characteristics as possible.• Normalize both the subject and comparable

companies’ financial statements (e.g. – non-recurring items).

• Calculate a variety of valuation multiples that can be applied to the fundamental financial variables of the subject company.Pricesubject = Earningssubject * [Pricecomparables ÷ Earningscomparable]

• Apply appropriate discounts/premiums: minority; marketability.

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Guideline Public Company MethodMultiples with low coefficient of variation are better. Multiples can be to equity or MVIC.

Equity Equity/Sales Equity/GCFEquity/ Net

IncomeEquity/ Book

ValueAlpha $8,942,500 1.72 25.55 59.62 2.50 Bravo $6,178,500 0.18 4.46 10.55 4.50 Charlie $13,000,000 0.20 1.82 2.31 6.50 Delta $42,000,000 0.72 12.59 15.84 4.00 Echo $33,675,000 0.35 3.50 7.04 1.50

Mean $20,759,200 0.63 9.58 19.07 3.80 Median $13,000,000 0.35 4.46 10.55 4.00 Range $6.1MM - $42.0MM 0.18-1.72 1.82-31.13 2.31-103.02 1.50-6.50Std Dev 0.64 9.84 23.20 1.92

Coefficient of Variation 1.02 1.03 1.22 0.51

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Guideline Public Company MethodAssign heavier weights to better multiples

($ thousands)

Subject Company Measures

Median Valuation Multiple

Indication of Value Weight

Weighted Value

MVIC/Sales 7,295 0.170 1,240.15 0.1 $124.02MVIC/EBITDA 1,599 5.010 8,010.99 0.6 4,806.59 MVIC/EBIT 1,526 5.060 7,721.56 0.3 2,316.47

Total weighted indications of MVIC value $7,247.08less: long-term debt 1,831

Indicated Value of Equity by Transaction Method $5,416.08

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Special Topics

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Special Purpose Valuations –Fair ValueWhat is Fair Value?• Accounting Standards Codification (ASC) 820

Definition:

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

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Special Purpose Valuations –Fair ValueASC 820 - key points regarding Fair Value• Most advantageous market• Independent buyers and sellers of the

reporting entity, that are• Knowledgeable of the asset or liability• Able to transact• Willing and motivated

to transact• Best possible use

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Special Purpose Valuations –Purchase Price AllocationASC 805 – Purchase Price Allocation• Instructions on how to allocate purchase

price across classes of acquired assets and liabilities

• Allocate the purchase price to identifiable individual assets and liabilities assumed based on fair value.

• Any remaining unallocatedamount shall be assignedto an asset called “goodwill”

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Special Purpose Valuations –Intangible AssetsASC 805 – Intangible Assets have …• Specific identification and recognizable

description• Legal existence and protection• The right of private ownership – transactable• Evidence of existence (e.g. a contract)• Identifiable time in which

it came into existence.• Identifiable time at which it

was destroyed or terminated.

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Special Purpose Valuations –Purchase PriceASC 805 – What is the Purchase Price?Cash payment + Fair value of any other assets distributed by buyer as consideration (e.g. marketable securities) + Fair value of liabilities incurred by the buyer (e.g. obligation of acquirer to transfer additional interests if specified conditions are met)Direct acquisition costs are EXPENSED (not added to the purchase price)

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Special Purpose Valuations –Purchase Price AllocationASC 805 – Allocating the Purchase Price• Unlike allocation for tax purposes, does not

recognize an assembled workforce in place as separable from goodwill.

• Buyer does not recognize any goodwill previously recorded by the acquired company.

• Buyer recognizes an appropriate deferred tax liability or asset resulting from differences between tax bases and assigned values of the acquired assets and liabilities assumed.

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Special Purpose Valuations –IntangiblesASC 805 – 5 Categories of Intangibles1. Marketing-related (e.g. trademarks)2. Customer-related (e.g. customer lists)3. Artistic-related (e.g. plays, operas, ballets)4. Contract-based (e.g. licensing

agreements)5. Technology-based (e.g. patented

technology)

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Special Purpose Valuations –Testing Goodwill ImpairmentASC 350 – Goodwill Impairment• No longer required to test at least annually,

but must make qualitative assessment.• When should we test for impairment? When

the weight of negatives exceeds positives.- Macroeconomic conditions- Industry conditions- Cost factors (e.g. increase in raw materials)- Overall financial performance- Others possible.

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Special Purpose Valuations –Goodwill ImpairmentASC 350 – Step One• Compare Fair Value of the business to the

Carrying Value of the assets and liabilities of the business.

• If Carrying Value is +/- 5% of its Fair Value, then auditors want a third party to value the business.

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Special Purpose Valuations –Goodwill ImpairmentASC 350 – Step One

Determine Entity Value $241,000Less: Debt -$4,000

Long-Term Debt -$152,500Indicated Value of Equity $84,500

Carrying Value on the Books $31,406

NO IMPAIRMENT

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Special Purpose Valuations –Goodwill ImpairmentASC 350 – Step One – a lousy year later

Determine Entity Value $158,000Less: Debt -$4,000

Long-Term Debt -$152,500Indicated Value of Equity $1,500

Carrying Value on the Books $31,406

IMPAIRMENT: MOVE TO STEP 2

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Special Purpose Valuations –Goodwill ImpairmentASC 350 – Step Two• Perform new purchase price allocation using

new valuation of $158 million• Value ALL intangible assets, including those

previously valued and any new intangibles that have been created.

• Goodwill impairment exists if the residual value is less than the carrying value of the goodwill.

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A Valuation Case Study

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Some BackgroundFamily Plumbing• Mike and Shirley Jones own Family, a C

corporation competing in the plumbing industry.

• They wish to gift 6,000 shares in the company to their children.

• $7.295 million in sales; 51 employees

• Low employee turnover• Fragmented, diverse

competition

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Some BackgroundEnvironmental AssessmentWhile certain risks exist in the local construction industries of Atlanta and northern Florida such as tight labor markets, increasing costs of supply, slowing demand for residential construction due to rising interest rates, the outlook favors sustained market growth. Strong growth in personal income, employment, and non-residential construction should mitigate the risks sufficiently to maintain current market growth over the planning period. However, it is reasonable to suspect profit margin pressure as costs increase faster than demand.

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Some BackgroundExcellent growth

$3,529

$4,156

$5,755

$6,489

$7,295

$3,000$3,500$4,000$4,500$5,000$5,500$6,000$6,500$7,000$7,500$8,000

2002 2003 2004 2005 2006

Sale

s ($t

hous

ands

)

Family Plumbing Inc. Sales

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Financial Statement AdjustmentsIncome Statement• Mrs. Jones compensation as office manager is

higher than industry norms.• However, this is a valuation of a minority

interest, so no adjustment there.• So just remove non-operating income.

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Some BackgroundRe-Cast Historical Income Statement

For the Year Ended June 30: (in 000's) 2006 2005 2004 2003 2002

Reported Net Income/(Loss) 933 889 785 444 402

Removing Other Income (84) (67) (53) (31) (22)

Income Tax Adjustment 33 25 20 13 9

Re-Cast Net Income 881 847 752 426 388

PEACHTREE PLUMBING, INC.Re-Cast Historical Income Sheet Summary

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Financial Statement AdjustmentsBalance Sheet• Land adjacent to the firm’s leased facilities

not supporting firm operations.• Adjust tangible PP&E to market values• Adjust inventory to FIFO• Excess cash & marketable securities

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Some BackgroundRe-Cast Balance Sheet

For the Year Ended June 30: (in 000's) 2006 Adjustments2006 Re-

Cast

AssetsCurrent Assets

Cash 1,403 (679) (1) 724Accounts Receivable (WIP) 891 891Inventory 49 5 (2) 54

Other Currrent AssetsLoans to Stockholders 0 0Short-term Investments 2,150 (2,150) (3) 0

Total Current Assets 4,493 (2,824) 1,669

Fixed AssetsProperty, Plant & Equipment 900 433 (4) 1,333Land 900 (900) (5) 0Other Fixed Assets 25 25

Total Fixed Assets 1,825 (467) 1,358

Other AssetsDeposits 150 150Other 0 0

Total Other Assets 150 0 150

Total Assets 6,468 (3,291) 3,177

Liabilities & EquityCurrent Liabilities

Notes Payable (Short-term) 135 135Accounts Payable 10 10Other Current Liabilities 3 3

Total Current Liabilities 148 0 148

Long-term LiabilitiesNotes Payable 1,831 1,831Other Long-term Liabilities 0 0

Total Long-term Liabilities 1,831 0 1,831

Stockholder's EquityCommon Stock 55 55Paid- in Capital 465 465Retained Earnings 3,969 (3,291) 678

Other EquityDividends 0 0

Total Other Equity 0 0 0

Total Stockholder's Equity 4,489 (3,291) 1,198

Total Liabilities & Equity 6,468 (3,291) 3,177

Adjustment notes:

(4) Increase total fixed assets to current market value of $1.36 million.(5) Remove value of land that is not supporting operations.

PEACHTREE PLUMBING, INC. Re-Cast Balance Sheet Summary

(1) & (3) In order to reduce cash and equivalents from 54.9% of total assets to the peer average of 11.2% of total assets, $2.8 million of cash and marketable securities must be removed from the balance sheet. $2.15 million was removed from marketable securities. The remaining $679 thousand was removed from cash.(2) Adjusting inventory value from a FIFO basis of $49 thousand to a LIFO basis of $54 thousand.

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Valuation Methodology• Family management tells us that the

competitive advantage of the firm lies in a loyal and motivated workforce that performs superior quality work.

• This capability is not recorded on a firm’s balance sheet.

• Lack of directly comparabletransactions.

• Therefore, an income approach is best.

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Valuation MethodologySingle period capitalization of earnings

Net Cash Flow Available to Stockholders (thousands)

Net income after taxes (1) $848+ Depreciation and non-cash charges (2) 0- Replacement of capital goods (2) 0- Change in working capital (3) 0

= Net Cash flow available to stockholders $848

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Valuation MethodologyWeighted average estimate: income increasing

For the Year Ended June 30: (in 000's) 2006 2005 2004 2003 2002Net Income

Re-Cast Net Income 881 847 752 426 388

Weighting Factors 3 2 1 0 0

Weighted Net Income 2,644 1,694 752 0 0

Sum of Weighted Net Income 5,090Total Weights 6Weighted Average Net Income 848

Re-Cast Historical Income Sheet Summary

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Valuation MethodologyCapitalization rate: buildup method• Risk-free rate –The return on a 20 year U.S. Treasury Coupon Bond Yield as

of December 31, 2005 is 4.6%.• Equity risk premium –Ibbotson Associates publishes the equity risk

premium from 1926 to 2005. This premium is measured as the difference between S&P 500 total returns and the 20-year Treasury bond return, is 7.1%.

• Size premium –Family Plumbing is smaller than even the smallest firms in the Ibbotson’s SBBI study. The size premium observed among the smallest firm in the smallest-cap decile is 9.83%.

• Industry premium –Ibbotson’s SBBI Yearbook 2006 reports that the premium attributable to the plumbing industry is 0.5%.

• Company-specific risk premium – This premium is applied after all other forms of risk, and measures the specific risk attributes of the subject company that are not captured in the other categories of risk. Often, empirical data is not available in order to calculate company specific risk. In these cases, we analyze the key factors that drive company specific risk as follows ….

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Valuation MethodologyCompany Specific Risk: 2.0%

Characteristic Direction Magnitude

Brand equity Decrease This is a modest decrease in risk. Mr. Jones has built a stronger-than-average reputation in his local industry.

Limited service offerings Increase This is a modest increase in risk. Family does not compete in all sections of the plumbing industry and is more vulnerable than average to the rate of new construction starts.

Financial strength Decrease This is a significant decrease in risk. Family is well managed and has an excellent balance sheet and income statement with a clear record of improving performance.

Management depth Increase This is a significant increase in risk. Mr. Jones has single-handedly enhanced the reputation of Family. The firm would suffer in his absence.

Company size Increase This is a significant increase in risk. Family is much smaller than even the smallest firms in the SBBI size study, and most firms in the RMA plumbing industry report.

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Valuation MethodologyCapitalization rate: 20.03%• Risk-free rate = 4.6%• Equity risk premium = 7.1%• Size premium = 9.83%• Industry premium = 0.5%• Company-specific premium = 2.0%• Long-term growth = 4.5%

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Valuation Methodology

Income Approach - Single Period Capitalization of Earnings (thousands)

Net cash flow available to shareholders $848Long-term sustainable growth rate (plus one) 1.045 Next year's normalized net cash flow available to shareholders $886.54Capitalization rate 20.03%

Marketable, minority value of the Company $4,426.04

Marketable, Minority interest value of the Company (rounded) $4,426.00

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Market Approach• Guideline Publicly Traded Companies: There

are no comparable publicly traded companies. Size, limited geographic coverage.

• Guideline Transaction Approach:- Quality Heating & Cooling is smaller than Family Plumbing Inc. in terms of net sales. The state in which the transaction occurred is not reported. Quality has much lower profitability than Family, and is less asset-intensive. While Family focuses in the plumbing industry, Quality Heating & Cooling is a heating, ventilation and air conditioning (HVAC) provider, which is a closely related industry segment.- Turner & Associates Plumbing Inc. is smaller but of comparable size to Family Plumbing Inc. The sale occurred in the same state as Family Plumbing. Turner operates in the same industry as Family. Turner is also much less profitable than Family, but has similar asset utilization.- Lindy Dennis Industries is much larger than Family, and operates in the HVAC industry segment. However, Lindy’s profitability and asset utilization is very comparable to Family’s.

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Market ApproachAdjustment to Deal Prices: Quality Pacific

Quality Pacific Heating & Cooling Deal Detail

Value ($millions)

Employment Agreement $0.772 Non-compete $0.160 Total Adjustment $0.932

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Market ApproachCalculate Multiples

Company Name MVIC MVIC/Sales MVIC/EBITDA MVIC/EBITQuality Pacific Heating & Cooling $0.680 $0.14 $5.04 $5.04Turner & Associates Plumbing, Inc. $0.720 0.17 5.01 7.85Lindy Dennis Industries, Inc. $25.462 0.69 4.68 5.06

Mean $8.954 0.332 4.909 5.982 Median $0.720 0.170 5.010 5.060 Range $0.72 - $25.46 0.14 - 0.69 4.68 - 5.04 5.04 - 5.06Coefficient of Variation 0.935 0.040 0.270

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Market ApproachWeight multiples using coefficient of variation

($ thousands)

Fundamentals from

Peachtree

Median Valuation Multiple

Indication of Value Weight

Weighted Value

MVIC/Sales 7,295 0.170 1,240.15 0.1 $124.02MVIC/EBITDA 1,599 5.010 8,010.99 0.6 4,806.59 MVIC/EBIT 1,526 5.060 7,721.56 0.3 2,316.47

Total weighted indications of MVIC value $7,247.08less: long-term debt 1,831

Indicated Value of Equity by Transaction Method $5,416.08

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Asset ApproachNet asset value can be considered a “floor value”• But this is a service-intensive business• Since we are valuing minority position, and

there are no plans to sell the business, the net asset value of the firm is irrelevant.

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Valuation AdjustmentsNon-operating assets = $3.7 million• $2.83 million in excess cash & marketable

securities• $900,000 of land

Valuation Approach ($thousands)Equity Value

Non-Operating

AssetsAdjusted

ValueSingle-Period Capitalization of Earnings (non-marketable, non-control baiss) $4,426 $3,729 $8,155Guideline Transaction Method (non-marketable, control basis) $5,416 $3,729 $9,145

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Valuation AdjustmentsDiscount for Lack of Control• Capitalization rate derived for single period

capitalization of earnings is based on publicly traded shares, which do not have control privileges.

• Mergerstat Industry Analysis 2005 indicates average control premium is 34.5%.

Valuation Approach ($thousands)Value including non-

operating assets

Lack of Control

Discount Adjusted ValueSingle-Period Capitalization of Earnings (marketable, non-control baiss) $8,155 $8,155Guideline Transaction Method (non-marketable, control basis) $9,145 34.5% $5,990

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Valuation AdjustmentsDiscount for Lack of Marketability

Mandelbaum v. Commissioner, T.C. Memo 1995-255

Factor Amount Discussion

Average/Benchmark Discount 35.0%Median Discount, pre-1990 Restricted Stock Studies

Nine Factors from Mandelbaum v. Commissioner, T.C. Memo 1995-255

Financial Statement -2.5% Peachtree has a very strong balance sheet and has exhibited excellent growth in sales and earnings over the study period.

Dividend Policy 2.0% The Company has no plans to offer dividends, and has not in the past.

History, Position, Outlook -2.0% Industry and regional economic analysis indicates a moderately upbeat market outlook coupled with exceptional competitive positioning.

Management 1.0% Current President Mike Jones highly skilled, but management depth is lacking. Mr. Jones is the key man upon which much business rests.

Control in Transferred Shares 0.5% This valuation is for a non-controlling interest.

Transfer Restrictions -0.5% Existing shareholders have a right of first refusal.

Holding Period 2.0% Closely held stock expected to be held for longer than average duration

Redemption Policy 0.5% Modest increase - no redemption policies in place

Public Offering costs. 0.0% No plans for IPO.

Total Adjustments 1.0%

Total Discount 36.0%

Discount for Lack of Marketability

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Lack of Marketability DiscountGuideline Transactions contains costs of marketability.

Valuation Approach ($thousands)

Value including non-operating assets, non-control basis

Lack of Marketability

DiscountAdjusted

ValueSingle-Period Capitalization of Earnings (marketable basis) $8,155 36.0% $5,219Guideline Transaction Method (non-marketable basis) $5,990 $5,990

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Reconciliation of Methods• Single Period Capitalization of Earnings is

directly tied to the earnings capacity of the firm.

• Guideline Transaction Method has problems:- Adequate comparable transactions are not available. - We are not able to determine the motivations behind the comparable transactions used. - The historical financial performances of the comparable firms are not available.

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Conclusion of Value

Single-Period Capitalization of Earnings

Equity Value $4,426,000Non-Operating Assets $3,729,000 Sub-total $8,155,000Discount for Lack of Control $0Discount for Lack of Marketability ($2,935,800)Non-marketable, non-controlling value $5,219,200Total shares 55,000 Price per Share $94.89Shares to be valued 3,000 Valuation of equity stake $284,684

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Why do acquiring companies pay so much?

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Learning ObjectivesUnderstand how firms negotiate a purchase

price in merger and acquisitions.Identifying synergy potential when two firms

join forces, and its importance in strategic management.

Apply these ideas toto a “real life” M&A example.

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Why do these smart guys pay so much for the firms they acquire?

Berkshire Uses Synergies to Justify Latest AcquisitionMarch 23, 2010

Berkshire Hathaway’s (BRK.A) McLane subsidiary has agreed to acquire Kahn Ventures, the parent company of Empire Distributors, Inc. Empire Distributors is a wholesale distributor of distilled spirits, wine, and beer operating mainly in the Southeastern United States. Empire Distributors was founded in 1940 by Max E. Kahn with two trucks, eight brands, and 149 customer accounts. The company expanded in subsequent decades and is still run by members of the Kahn family.McLane is engaged in the wholesale distribution of grocery and non-food items to retailers, convenience stores, and …

Why Microsoft Overpaid for FacebookOctober 25, 2007

At first blush, it may seem like Microsoft got the short end of the deal when it paid $240 million on Wednesday for a puny 1.6% stake in the social-networking site Facebook. While Facebook is probably the most talked about destination on the Web today, the company will be lucky to clear $30 million in profit (on an estimated $140 million in revenues) this year. So what exactly was Microsoft buying, other than a lot of hope and, quite possibly, a lot of hype?With $23 billion in cash reserves, the Redmond, Wash.–based software giant can afford to part with a little cash — even if it never earns a penny of it back.

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How much should I pay?

For an almost impossible to find part that will put my fully restored 1969 Camaro SS back on the road?

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Question

Can you make money in real estate if housing prices are stable?

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Acquiring firms must “do something” with the firms they acquire in order to

make them worth more than the price paid to the acquired firm’s owners.

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Monday, March 9, 2009

Amazon markets using TwitterPuget Sound Business Journal (Seattle)

Online retail giant Amazon.com is boosting its use of Twitter, the popular micro-blogging service, to get the word out about product deals and services.Amazon appears to have started using Twitter in 2007, and has attracted thousands of followers to updates on its MP3 digital music service, product deals and video game offerings. In recent months, Amazon has made new forays into Twitter, setting up accounts for its payments service and wishlist feature.It’s unclear how much web traffic and revenue Amazon is deriving from Twitter. But Seattle-based Amazon is part of a growing list of companies, including Comcast, Dell, Starbucks, and Whole Foods, that are experimenting with the service to build buzz around products and drive web traffic and sales.Ben Weisman, digital director for the New York office of marketing agency Iris Nation, said Amazon is “absolutely on the front lines” of using Twitter and said the online retailer needs to have a presence there to stay connected to its online user base.Twitter allows users to send text-based updates, known as “tweets,” and read the tweets of others. The short, 140-character updates can be sent via mobile phone or the web.Twitter, which is a free service, has attracted legions of users but is still trying to work out a revenue model.Amazon’s relationship with Twitter goes deeper than just marketing. Amazon.com founder and CEO Jeff Bezos was an early personal investor in Twitter through his private firm Bezos Expeditions, and Twitter uses Amazon’s web service S3 to store user profile photos and back up data.Amazon spokesman Craig Berman confirmed some of the Amazon Twitter accounts, but declined to provide additional details, saying that “we are constantly experimenting with ways to make it easier for customers to find, discover and buy anything they may want on the internet.”

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An exampleA national broadband TV provider acquires a

regional broadband TV provider.All the information used in this example were

found in publicly available documents, EXCEPT …

Extensive analysis is required in order to estimate the value of the synergies.

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Potential SynergiesCustomer revenue stimulationReduced technical and operating expensesReduced SG&A expenses

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Valuing the Target FirmThe target firm’s fair market value by calculating the firm’s enterprise value. This is calculated as follows:

Target firm’s enterprise value = (average daily share closing price for past month) * (total shares outstanding) + firm debt +

preferred shares – cash and cash equivalents.

Substituting in the appropriate values from Table 1 yields the following:

Target firm’s enterprise value ($millions) = ($33.77 * 300.05) + $10,260.6 + $0 - $354.75 = $20,037.83 million.

$20.0 billion

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What acquiring firm must payMany times (but not always), selling

shareholders can negotiate a premium over market price.

Why might that be?Only equity owners

have voting rights.

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Purchase equity at premiumThe market value of equity is the price per share times the total number of shares outstanding:

$33.77 * 300,050,000 = $10.13 billion

Technically, we must acquire only a majority of the shares in order to acquiring voting control of the firm. However, for this deal, let’s assume that we acquire the entire firm, and pay a premium on all outstanding shares.

Thus the total purchase price of all of the outstanding shares of the target firm is $12.16 billion.

$10.13 billion market value of equity plus $2.03 billion takeover premium

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Paying for that premium

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How Can We Determine If We Can Afford the Takeover Premium?

Forecast the cash flow of the firm without any changes.Forecast the cash flow impact of the synergies.Determine if synergy value is greater than the premium.

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The “Momentum” Revenue ViewBase year, plusInflation (2% per year)Ongoing promotion (2% per year)

Table 2: Projecting Momentum Sales

($millions) t-2 t-1 t t+1 t+2 t+3 t+4 t+5 t+6 Base Year Sales $6,484 $7,230 $7,773 $7,773 $7,773 $7,773 $7,773 $7,773 $7,773 with Inflation $7,929 $8,087 $8,249 $8,414 $8,582 $8,754 with Ongoing Promotion and Innovation $8,087 $8,414 $8,754 $9,108 $9,476 $9,858

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The “Momentum” Income StatementAdjusting percentages of revenue over time

($millions) t-2 t-1 t BOP % of sales t+1 t+2 t+3 t+4 t+5 t+6

EOP % of sales

Revenues, net $6,484.5 $7,230.1 $7,773.3 100% $8,087.3 $8,414.0 $8,754.0 $9,107.6 $9,475.6 $9,858.4 100% Operating expenses: Technical and operating $2,891.6 $3,244.4 $3,369.0 43% $3,505.1 $3,632.2 $3,759.3 $3,886.4 $4,013.4 $4,140.5 42% Selling, general and administrative $1,558.7 $1,739.2 $1,893.8 24% $1,970.3 $2,029.7 $2,089.2 $2,148.6 $2,208.0 $2,267.4 23% Depreciation and amortization $1,118.9 $1,507.8 $1,084.2 14% $1,128.1 $1,158.8 $1,189.5 $1,220.2 $1,250.9 $1,281.6 13% Operating income (loss) $915.3 $738.7 $1,426.2 18% $1,483.8 $1,593.3 $1,716.1 $1,852.5 $2,003.2 $2,168.8 22% Income tax benefit (expense) $320.3 $258.6 $499.2 6% $519.3 $557.7 $600.6 $648.4 $701.1 $591.5 6% Income (loss) from continuing operations $594.9 $480.2 $927.0 12% $964.5 $1,035.7 $1,115.4 $1,204.1 $1,302.1 $1,577.3 16% Net income (loss) $594.9 $480.2 $927.0 12% $964.5 $1,035.7 $1,115.4 $1,204.1 $1,302.1 $1,577.3 16%

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Revenue Stimulation Synergy

($millions) t+2 t+3 t+4 t+5 t+6 Revenues, net $420.7 $875.4 $910.8 $947.6 $985.8 Operating expenses: Technical and operating $0.0 $0.0 $0.0 $0.0 $0.0 Selling, general and administrative $0.0 $0.0 $0.0 $0.0 $0.0 Depreciation and amortization $0.0 $0.0 $0.0 $0.0 $0.0 Operating income (loss) $420.7 $875.4 $910.8 $947.6 $985.8 Income tax benefit (expense) $147.2 $306.4 $318.8 $331.6 $345.0 Income (loss) from continuing operations $273.5 $569.0 $592.0 $615.9 $640.8 Net income (loss) $273.5 $569.0 $592.0 $615.9 $640.8

Revenue per customer increases 10%.

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Network Expense Synergy

Technical and operating expenses decrease 10%.

($millions) t+2 t+3 t+4 t+5 t+6 Revenues, net $0.0 $0.0 $0.0 $0.0 $0.0 Operating expenses: Technical and operating -$181.6 -$375.9 -$388.6 -$401.3 -$414.1 Selling, general and administrative $0.0 $0.0 $0.0 $0.0 $0.0 Depreciation and amortization $0.0 $0.0 $0.0 $0.0 $0.0 Operating income (loss) $181.6 $375.9 $388.6 $401.3 $414.1 Income tax benefit (expense) $63.6 $131.6 $136.0 $140.5 $144.9 Income (loss) from continuing operations $118.0 $244.4 $252.6 $260.9 $269.1 Net income (loss) $118.0 $244.4 $252.6 $260.9 $269.1

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SG&A Expense Synergy

($millions) t+2 t+3 t+4 t+5 t+6 Revenues, net $0.0 $0.0 $0.0 $0.0 $0.0 Operating expenses: Technical and operating $0.0 $0.0 $0.0 $0.0 $0.0 Selling, general and administrative -$253.7 -$522.3 -$537.1 -$552.0 -$566.9 Depreciation and amortization $0.0 $0.0 $0.0 $0.0 $0.0 Operating income (loss) $253.7 $522.3 $537.1 $552.0 $566.9 Income tax benefit (expense) $88.8 $182.8 $188.0 $193.2 $198.4 Income (loss) from continuing operations $164.9 $339.5 $349.1 $358.8 $368.5 Net income (loss) $164.9 $339.5 $349.1 $358.8 $368.5

SG&A expenses decrease 10%.

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Putting Synergies Together

($millions) t+2 t+3 t+4 t+5 t+6 Revenues, net $420.7 $875.4 $910.8 $947.6 $985.8 Operating expenses: Technical and operating -$181.6 -$375.9 -$388.6 -$401.3 -$414.1 Selling, general and administrative -$253.7 -$522.3 -$537.1 -$552.0 -$566.9 Depreciation and amortization $0.0 $0.0 $0.0 $0.0 $0.0 Operating income (loss) $856.0 $1,773.6 $1,836.5 $1,900.9 $1,966.7 Income tax benefit (expense) $299.6 $620.8 $642.8 $665.3 $688.4 Income (loss) from continuing operations $556.4 $1,152.9 $1,193.8 $1,235.6 $1,278.4 Net income (loss) $556.4 $1,152.9 $1,193.8 $1,235.6 $1,278.4

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Valuing the SynergiesNow that we have the net income impact of the synergies, just calculate free cash flow impact.Free cash flow = NOPAT lessworking capital impact lesscapital expenditure plusdepreciation & amortization

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Free Cash Flow ForecastCan we afford takeover premium and network investment?

($ millions) t+2 t+3 t+4 t+5 t+6

NOPAT $556.42 $1,152.85 $1,193.75 $1,235.59 $1,278.39 Change in Working Capital $39.95 $43.08 $3.25 $3.36 $3.49 Capital Expenditure $10.00 Takeover Premium $2,026.40 Depreciation and Amortization $1.00 $1.00 $1.00 $1.00 $1.00 Free Cash Flow -$1,518.92 $1,110.77 $1,191.51 $1,233.22 $1,275.90

Present Value Cash Flow -$1,435.25 $937.13 $897.54 $829.43 $766.19 Cumulative Present Value Cash Flow -$1,435.25 -$498.12 $399.42 $1,228.84 $1,995.03 Terminal Value $3,244.88 Net Present Value $5,239.92

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A “Re-Look” at the Deal

$2 billion takeover premium

$7 billion in “synergies”

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How might we value innovation?

Another Way to Value Technology

• Most patents are useless• Citations to patents are a strong

determinant of the market value of the firms that hold them (Trajtenberg, 1990; Hall, Jaffe & Trajtenberg, 2005)

• But …. not all citations are equal (Hall, Jaffe & Trajtenberg, 2001)

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Citations over Time

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Patenters cite more nowadays..

Newer patents have had less

time to be cited

Hall, Jaffe & Trajtenberg, 2001

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Citations by Industry

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Computer geeks cite a lot more

than mechanical engineer geeks

Hall, Jaffe & Trajtenberg, 2001

How Do We Compare Firms’ Patent Portfolios?

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• The most important metric to observe is the citations that your firm’s patent receives.

• However, those citations must be adjusted based on the amount of time the patent has been available to cite, and the propensity to cite in its industry.

• The “fixed effects” approach (Hall, Jaffe & Trajtenberg, 2001)

A Straightforward Calculation

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ti,

ti,

tf,tf,

granted patents received citations received citations * patents

1. Divide the citations to the patents your firm possesses by the average citations received by all the patents in the same technological class, in the same year.

2. Multiply that by the number of patents your firm holds.

Hall, Jaffe & Trajtenberg, 2001

• Compare the value of the patent portfolios of two firms by comparing their fixed-effects adjusted citations to their patents.

• Use this approach to triangulate with other valuations.

Potential Uses?

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So Where is this Stuff ?

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Free! On the web!http://www.nber.org/patents/