pricing companies and m&a - s3

8/9/2019 Pricing Companies and m&a - s3

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RiskmathicsPricing Companies and Mergers & Acquisitions

Day 3


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Adjustments in Valuation


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Adjustments

The most significant errors in valuation occur after you think you aredone, where you are tempted to start adding or subtractingarbitrary amounts from your carefully estimated value for items thatsound reasonable - illiquidity, control, synergy, etc.

We have to fight this temptation because it undercuts the integrity of

the entire valuation process... Illiquidity, control, synergy could wellbe important but we should try to assess the value rather thanassume that it is always 25% or some other arbitrary amount of theestimated value.


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Changing the Dish

A $324 bowl of noodles at NiuBa Ba in Taipei, Taiwan (Chef:

Wang Cong-yuan).

$1.25 instant noodles.


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AdjustmentsEnterprise Value (EV) PV(FCFF) Value of operating assets = EV

+ Value of Cash Operating vs. non-operating cashDiscount cash?

+ Other Non-Operating Assets Unused or underutilized assets?+/- Holdings in Other Companies Majority vs. minority holdings

How to value holdings? What if non-public firms?Add or subtract?

= Value of Firm Discount for complexity of the firm?Premium for intangibles (e.g., brand name)?

- Value of Debt Interest-bearing debtBook or market value?

- Value of Other Liabilities Underfunded pension and health liabilities?Law suits and other contingent liabilities?

= Value of Equity Truncation risk?

Premium for control?

- Value of Equity in Options Issued vs. future options?Vested vs. non-vested?How to value options?

= Value of Equity in Common Stock

= Value of Equity in Common Stock / # Shares Divide by primary, diluted, or outstanding shares?Discount for illiquidity?


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1) Value of Cash


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The Value of Cash

An analyst is valuing a company with a significant cash balance andargues that the market will penalize the company for holding cashbecause the cash earns a return that is lower than the companyscost of capital (WACC).

True?

False?


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Whats the Value of 100 Mexican Peso of Cash?(Inside a Company)


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Dealing with Cash in Valuation

The simplest and most direct way of dealing with cash is to keep itout of the company valuation until the very end.

The cash flows should be before interest income from the cash, andthe discount rate should not be contaminated by the cash.

Once the operating assets have been valued, you simply add backthe value of the cash. Separate the valuation of operatingassets and cash.

But


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Example

When does cash have a discount?

When does cash have a premium?


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Example: Hewlett Packard

Recent history of very bad acquisitions.

Two very large acquisitions ($13.9B for Electronic Data Systems and$11B for Autonomy), but written off about $8B of that already.

Companies dont own cash they manage the cash on behalf of

their shareholders.

Do you want HP to manage yourcash?


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Discount Cash?

Some analysts argue that (excess) cash should be discountedbecause it earns a low return. Not correct!

If the cash is invested in marketable securities (e.g., governmentbonds), it should earn a low return. If the return is the risk-free rate,given that it is a risk-free investment, cash does neither add, nor

destroy, the value of the company.

Managers can do suboptimal and stupid things with cash (e.g.,overpriced acquisitions, pie-in-the sky projects) and you have toaccount for this possibility. This is the reason to discount cash!

Discount should be a function of corporate governance, past historyof the company/management/acquisitions, etc.


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Market Value of $1 in Cash


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2) Other Non-Operating Assets


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Other Non-Operating Assets?

Assume you have discounted FCFF at the WACC and have anenterprise value. Should you add the present value of:

Headquarter building in Hong Kong?

Vacant land owned by the company in Australia?

Patents (currently used in the production of the products)?

Brand name (accounting estimate of the intangible value)?

Art collection (acquired by current CEO, using corporate funds)?

Goodwill?


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Example: The Playboy Mansion ($80-100M)

Hugh Heffner, 1926-?


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Other Non-Operating Assets

Unused or underuti lized assets: If firm has assets that are not fully utilized, you have not valued it!

Value the asset and add to the value of the firm.

Overfunded corporate pension plan: If firm has defined benefit plan and its value exceeds the firms expected

pension liability.Add excess pension plan value to the firm.

Caveats: Collective bargaining agreement may prevent firm from claiming the plan. Withdrawls from pension plans may get taxed at much higher rates.


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3) Holdings in Other Companies


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Categories of Holdings in Other Companies

Minority passive holdings. Only dividends from the holdings are shown in the income statement (below

operating income line), and original investment on the balance sheet. Example: At one point, 70% of Japanese VC firm SoftBank was Yahoo holding

(a few years after the initial minority investment). Still, nothing showed up inSoftbanks income statement because Yahoo didnt pay dividends, and only$50M in balance sheet though it was worth $7B!

Minority active holdings. Most minority holdings are active (e.g., sit on the board). The portion of net income is shown in the income statement, but below the

operating income line, and the original investment plus the portion of

retained earnings on the balance sheet.

Majority active holdings. The financial statements are 100% consolidated. Minority interest.


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Example: Tata Motors Holdings


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Example

Assume that you have valued Company A using consolidatedfinancials for $1B (using FCFF and WACC) and that the firm has

$200M in debt. How much is the equity in Company A worth?

Now assume that you are told that Company A owns 10% ofCompany B and that the holdings are accounted for as minority

passive holdings. If the market cap of Company B is $500M, howmuch is the equity in Company A worth?

Now add on the assumption that Company A owns 60% of CompanyC and that the holdings are fully consolidated. The holding in

Company C is booked at $40M in Company As balance sheet(minority interest). How much is the equity in Company A worth?

What are the problems?


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In Perfect World

1) Value the parent company without any holdings. This will requireusing unconsolidated financial statements for both parents and each

holding rather than using consolidated ones.

2) Value each of the holdings individually. If use the market values ofthe holdings, errors the market makes in valuing them are automatically

built into the valuation, which is not good.

3) Value of the equity in the parent company with N crossholdings:

Value of non-consolidated parent company

Debt of non-consolidated parent company

+ j)CompanyofDebt-jCompanyof(ValuejCompanyofOwned%1

Nj

j


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Toyota Japanese Nightmare (Keiretsu)


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Compromise in Practice

1) Market value method: If the holdings are publicly traded, takemarket value and multiply by proportion the firm holds. (If market is

misvaluing the holding, you would carry that mistake over, if you dontvalue also the holding intrinsically.) If the holding is a considerableportion (>10%) of the value of the company, it is worth consideringdoing a DCF of the holding.

2) Relative valuation method: Convert the book values you have onthe balance sheet by using the average price to book (P/B) ratio ofthe industry in which the holdings operate. Clearly imperfect, butmost often better than relying on book values being equal to market

values, and often this is all the information that is available anyway,so we cant really do any better than this.


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4) Complexity


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Example

You are an investor valuing two exactly identical firms based onfinancial information identical operating income, growth, risk, return

on capital etc. Company A is in a single business and has transparentfinancials. Company B is complex and in multiple businesses, withopaque structure. Which firm, if any, would you value more highly?

Company A: It is simple to value.

Company B: It is more diversified and therefore has lower risk.

Neither: They have the same financials and should have the same value.


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Complexity in Valuation

There is no room for complexity in standard valuation models.

Why not? Because this is one of these idiosyncratic firm-specificfactors that is diversified away in the CAPM. What companies donttell investors cant hurt them.

Is this really a realistic assumption? You invest in 100 complexcompanies, and firm-specific idiosyncrasies cancel each other outbecause of diversification. What information do managers not tellinvestors? Good news or not-so-good news?

Accounting scandal: We made $5M more than we previously told you!


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Example: Tyco International

Acquisition growth strategy.

Created very complex company.

Management decided to not reveal bad information, which waspossible (in the short term) because of complexity.

When revealed, Tycos stock 80% .

Interestingly, GEs stock 15% . Why?


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Company Number of Pages in 10KGeneral Electric 410

Microsoft 218

Walmart 244

Exxon Mobil 332

Pfizer 460Citigroup 1026

Intel 215

AIG 720

Johnson & Johnson 218

IBM 353

Amount of Data in Financial Statements


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Complexity ScoreOperating Income Complexity Weight Complexity Factor

Multiple business segments Number of businesses (with >10% of revenues) 15 2 30

One-time income or expenses Percent of operating income 8.00% 10 0.8

Income or expenses from non-specified sources Percent of operating income 12.00% 10 1.2

Items in income statement that are volatile Percent of operating income 20.00% 5 1

Tax Rate Multiple geographical segments Percent of revenues from non-domestic countries 60.00% 3 1.8

Different tax and reporting books Yes / No Yes 3 3

Headquarters in tax haven Yes / No No 3 0

Volatile effective tax rate Yes / No No 2 0

Capex & Acquisitions

Volatile capital expenditures Yes / No Yes 2 2

Frequent and large acquisitions Yes / No Yes 4 4

Stock payment for acquisitions Yes / No Yes 4 4

Working Capital

Non-specified current assets and current liabilitiesYes / No No 3 0

Volatile working capital Yes / No Yes 2 2

Growth

Off-balance sheet assets and liabilities (operating leases and Yes / No Yes 3 3

Significant stock buybacks Yes / No Yes 3 3

Volatile return on capital Yes / No Yes 5 5

Unsustainably high return on capital Yes / No No 5 0

Cost of Capital


Operations in emerging markets Percent of revenues in emerging markets 50.00% 5 2.5

Public debt Yes / No Yes 2 0

Debt rating Yes / No Yes 2 0

Off-balance sheet debt Yes / No Yes 5 5

Adjustments

Holdings in other companies Percent of book assets 4.00% 20 0.8

Dual-class shares Yes / No No 10 0

Equity options Percentage of shares outstanding 2.50% 10 0.25

Complex ity Score 88.3


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Complexity Score: Study

No correlation between Complexity Score and size of firm. Some small companies are very complex.

Some large companies are simple.

Emerging market companies are 15-20% more complex than firmsin developed markets, primarily because of crossholdings.

The most transparent company in study: Indian company Infosys. Disclosure laws in emerging markets put a floor, not a cap, ondisclosure. Companies can choose not to be complex.

Firms that grow through acquisitions are about 25% more complexthan those that grow internally.

Companies with a capital/financing arm (e.g., GE Capital) are alsomuch more complex.


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Most Complex Company in StudyOperating Income Complexity Weight Complexity Factor


One-time income or expenses Percent of operating income 8.00% 10 0.8

Income or expenses from non-specified sources Percent of operating income 12.00% 10 1.2

Items in income statement that are volatile Percent of operating income 20.00% 5 1

Tax Rate Multiple geographical segments Percent of revenues from non-domestic countries 60.00% 3 1.8

Different tax and reporting books Yes / No Yes 3 3

Headquarters in tax haven Yes / No No 3 0

Volatile effective tax rate Yes / No No 2 0

Capex & Acquisitions

Volatile capital expenditures Yes / No Yes 2 2

Frequent and large acquisitions Yes / No Yes 4 4

Stock payment for acquisitions Yes / No Yes 4 4

Working Capital

Non-specified current assets and current liabilities Yes / No No 3 0

Volatile working capital Yes / No Yes 2 2

Growth

Off-balance sheet assets and liabilities (operating leases and Yes / No Yes 3 3

Significant stock buybacks Yes / No Yes 3 3

Volatile return on capital Yes / No Yes 5 5

Unsustainably high return on capital Yes / No No 5 0

Cost of Capital


Operations in emerging markets Percent of revenues in emerging markets 50.00% 5 2.5

Public debt Yes / No Yes 2 0

Debt rating Yes / No Yes 2 0 Off-balance sheet debt Yes / No Yes 5 5

Adjustments

Holdings in other companies Percent of book assets 4.00% 20 0.8

Dual-class shares Yes / No No 10 0

Equity options Percentage of shares outstanding 2.50% 10 0.25

Complex ity Score 88.3


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Dealing with Complexity

DCF: Aggressive analyst: No adjustment for complexity.

Conservative analyst: Avoid investing in complex companies altogether. Compromise. Value the firm and adjust for complexity:

Cash flows. Cost of capital. Growth rate and length of growth period.

Multiples: Regression for 100 largest market cap firms: PB = 0.65 + 15.3 ROE 0.55 Beta + 3.04 Expected g 0.003 # 10K Pages 100 additional 10K pages lowers PB ratio by 0.3.


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5) Value of Intangibles


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Example

Suppose you estimate the value of Coca Cola using FCFF andWACC. At the end of the valuation, what is a reasonable premium to

add for the Coca Cola brand name?

5-10% premium.

25% premium.

Some other premium.


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Example: Coca Cola vs. Cott

Coca Cola with Cott's Operating Margins

Revenues $21,962.00 $21,962.00

High growth period

Length 10 10

Reinvestment rate 50% 50%

Operating margin (after tax) 15.57% 5.28%

Return on capital (after tax) 20.84% 7.06%

Growth 10.42% 3.53%

WACC 7.65% 7.65%Stable growth period

Reinvestment rate 52.28% 52.28%

Return on capital (after tax) 7.65% 7.65%

Growth 4% 4%

WACC 7.65% 7.65%

Value of Firm $79,611.00 $15,371.00

Value of Brand Name = $79,611 - $15,371 = $64,240

Premium = $64,240 / $15,371 = 317%


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Which Smart Phone Has the Strongest Brand?


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Which Brand is Most Difficult to Value?

Coca Cola?

Sony?

Goldman Sachs?


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The Goldman Sachs reputation.

One of the most difficult intangibles to value.

Seems to be able to get out a little but before everyone else (e.g., dot-com stocks, mortgage-backed securities, etc.) Put option.

Adding a premium for this is clearly very difficult!

Example: Goldman Sachs


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WD-40 in Shanghai

Fake


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Valuing Different Categories of IntangiblesIndependent and cash flow

generating intangibles

Not independent and cash flow

generating to the firm

No cash flow now but potential for

cash flows in future

Examples Copyrights, trademarks,

licenses, franchises,professional practices

(medial, dental)

Brand names, quality and morale

of work force, technologicalexpertise, corporate reputation

Undeveloped patents, operating or

financial flexibility (to expand intonew products/markets or abandon

existing ones)

Valuation Estimate expected cash

flows from the product or

service and discount back atappropriate discount rate.

Compare DCF value of firm with

intangible with firm without (if you

can find one).Assume that all excess returns of

firm are due to intangible.

Compare multiples at which firm

trades to sector averages.

Option valuation

Value undeveloped patent as option

to develop the underlying product.Value expansion option as call

option.

Value abandonment option as put

option.

Challenges Life is usually finite and

terminal value may be small.

Cash flows and value may

be person dependent (for

professional practices).

With multiple intangibles (brand

name and reputation for service), it

becomes difficult to break down

individual components.

Exclusivity is required.

Difficult to replicate and arbitrage

(making option pricing models

dicey)


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6) Value of Debt


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Whats Debt?

For WACC estimation. Focus on only interest-bearing debt, bothlong-term and short-term.

Dont try to be conservative by including extra items in debt whenestimating the cost of capital because that will simply reduce theWACC and increase the value of the firm (not conservative!)

When deducting Debt from Firm Value. Could be moreexpansive in the definition of debt.


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Lawsuits and Other Contingent Liabilities

5-10% of large U.S. companies are subject to lawsuits at any givenpoint in time

BlackBerry: An individual claimed they stole the core technologycontent took 5 years to resolve litigation. How to value?

Phillip Morris (tobacco) lost lawsuit. $5B (!) liability.

Merck: Sued for Vioxx. Settled for much less than the lawsuit.

Value of Contingent Liability = Probability Liability Occur x Value of

Liability Contingent on Occurring.


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7) Value of Control


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Controlling vs. Minority Shareholders

Controlling shareholders decide:

Strategy.

Companies to acquire. Capital expenditures.

Dividends.

Board.

Etc.

Minority shareholders have little (if any) to say on these matters;their rights are to participate in dividends (which controlling

shareholders decide on), and capital gains (if there are any).


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What is the Value of Control?

1) The probability that control of the firm will change.

The probability that management will be replaced, either through i)

acquisition, or ii) existing shareholders exercising governance.

2) Value of controlling the company.

This means i) the increase in value that can be brought by changes in

the way the company is managed and run, and ii) the private benefits ofbeing in control.

Value of Control = Expected Value (Value of Company with Change

in Control Value of Company without Change in Control) + PrivateBenefits of Control.


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Zero Probability of Change in Control?


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8) Truncation Risk


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Going Concern Assumption

Standard valuations are built on the assumption of a going concern,i.e., the firm has continuing operations and there is no significant

threat to these operations. DCF: Terminal value based on infinite life.

Multiples: Most comparables are non-distress firms.

If there is significant truncation risk, i.e., the firm will stop existing oryour equity position will be extinguished, the going concern valueovervalues the company.


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Examples of Truncation Risks

Act of God: Hurricanes, typhoons, earthquakes, etc.

Terrorism and war: Investing in Afghanistan

Expropriation: In some countries, successful businesses can betargeted by governments for expropriation (e.g., oil companies in

Argentina or Russia), with equity investors getting well under the fairvalue as their compensation.

Default / Distress / Failure: If a company cant produce enough cash

flows from operations and/or raise external capital, then game over.


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Methods

1) Adjust cash flows: Very difficult, and increasingly so over timebecause you have to consider the cumulative probability of the

truncation risk event over time.

2) Adjust cost of capital: Dramatically jack up the discount rate isproblematic because reflects increased probability of both poor, but

also good, cash flows in the future.

3) Scenarios:

Truncation event with probability 1-p.

Non-truncation event (normal state-of-the -world) with probability p. Estimate the expected value.


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9) Employee Stock Options


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David Choe

A graffiti artist who painted the walls of Facebooks first offices in PaloAlto, California, was paid with 3.77 million stock options in the

company, which were worth $144.2 million at the IPO


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Stock Options

In recent years, firms in the U.S. (and increasingly so also in Europe)have started to use employee stock options, particularly to executives,

as a part of their compensation.

These stock options are generally:

Long term expiration time.

Issued at-the-money. On volatile stocks (e.g., start-up and tech companies).


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Why Do Stock Options Affect Firm Value?

Any options issued by a firm, whether to executives, or to employees,or to investors (= convertibles and warrants) create claims on the

equity of the firm. Lower value to common stock.

Failing to fully take into account this claim on the equity in valuation willresult in an overestimation of the value of equity per share.


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Effects of Stock Options

i) Effect of options granted in the past.

ii) Effect of expected future options.

) O G


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i) Options Granted in the Past

Collect data on all options outstanding (vested + non-vested), withaverage exercise price and average time to expiration.

Value these options, taking into account early exercise, dilutionadjustment, vesting, etc.

Subtract the value of all the options from the value of the equity anddivide by the actual number of shares outstanding (NOT diluted orpartially diluted number shares).

E l


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Example

XYZ company has $100M in FCFF, growing 3% a year in perpetuityand a WACC of 8%. It has 100M shares outstanding and $1B in debt.

Value of firm = $100M / (0.08 0.03) = $2,000M

- Debt - $1,000M

= Equity = $1,000M

Equity per share $1,000M / 100M = $10

E l C td


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Example, Contd

XYZ decides to give 10M options at the money (with exercise price of$10) to its CEO and other top-executives. What effect will this have

on the value of equity per share?

None, because the options are not in-the-money.

Decrease by 10%, because the number of shares will increase by 10M.

Decrease by less than 10%, because the options will bring in cash into thefirm but they have time value.

D li ith O ti th C t W


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Dealing with Options the Correct Way

1) Value the operating assets of the firm. Enterprise Value.

2) Adjustments. Value of Equity (i.e., all of the equity).

3) Subtract (estimated) value of other equity claims:

Value of Employee Options: Adjusted Black-Scholes.

Value of Warrants = Market Price per Warrant x Number of Warrants.

Value of Conversion Option = Market Value of Convertible Bonds - Valueof Straight Debt Portion of Convertible Bonds.

4) Divide the value of equity in common stock by the number of sharescurrently outstanding.

E ample Contd


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Example, Contd

Current stock price = $10.

Weighted-average exercise price = $10.

Weighted-average time to expiration = 10 years. Annualized standard deviation = 40%.

Annualized dividend yield = 0%.

Risk-free rate = 4%.

Using a dilution-adjusted Black-Scholes model:

N (d1) = 0.8199

N (d2) = 0.3624

Value per option = 0.8199x$9.58 - 0.3624x$10xexp[-(0.04)(10)] = $5.42

Dilution-adjusted stock price = $9.58

(100M x $10 + 10M x Value of Option) / (100M + 10M).

Iterations in Excel solves the circularity


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Example Contd


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Example, Cont d

Using the value per call option of $5.42, we can now estimate thevalue of equity per share considering options:

Value of firm = $100M / (0.08-0.03) = $2,000M

- Debt - $1,000M

= Equity = $1,000M

Value of options already granted = $54.23MAdjusted for vesting & tax $29.29M

= Value of equity in common stock = $970.71M

/ Number of shares outstanding / 100M

Equity per share = $9.71

ii) Expected Future Options


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ii) Expected Future Options

Estimate the value of option granted each year over the past severalyears as a percent of revenues.

Forecast out the value of option grants as a percent of revenues intofuture years, allowing for the fact that as revenues get larger, optiongrants as a percent of revenues will become smaller.

Consider this line item as part of operating expenses each year. Thiswill reduce the operating margin and cash flow each year.


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Valuation of Private Companies

Process for Valuing Private Companies


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Process for Valuing Private Companies

In principle, the valuation process is the same as when valuing apublic company (e.g., discounting FCFF using WACC).

But generally two problems compared to public company valuation:

i) No market value for neither debt nor equity.

ii) Financial statements issues because they generally go back feweryears, have fewer details, and have many more holes in them.

i) No Market Values


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i) No Market Values

You may not realize how much you use market values in DCFvaluation until you dont have them

Market values as inputs: No market value of debt or equity. Any inputs that require them

cannot be estimated (e.g., no D/V ratio to lever betas). No market prices to value options to employees.

Market value as output: When valuing public companies, themarket value on the stock exchange serves as a measure ofreasonableness. For a private company, the value stands alone(sometimes very lonely)

Market price based risk measures, such as beta and debt ratings,are generally not available for private firms.

ii) Financial Statements


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ii) Financial Statements

Shorter history: Private firms often have been around for muchshorter time periods than most public firms. Less historical

information available on them.

Intermingling of personal and business expenses: In the case ofprivate firms, some personal expenses may be reported as businessexpenses (e.g., company car for private use).

Separating salaries from dividends : It is difficult to knowwhere salaries end and dividends begin in a private firm, since theyboth end up with the owner.

Different accounting standards : The accounting statements forprivate firms are often based upon different accounting standardsthan public firms (not GAAP!), which operate under much stricterconstraints on what and when to report.

Post-It-Note Accounting GAAP


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Post It Note Accounting GAAP

Can Not Value Private Companies


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Without Knowing Why? Show valuation: Curious how much the business is worth

Estate taxes.

Divorce court.

Sale to a private company.

Sale to public company.

IPO.

Depending on why, the value of a private company will be different!

Private to Private Transaction


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Private to Private Transaction

In private to private transactions, a private business is sold by oneindividual to another. There are three key valuation challenges we

have to confront in such transactions:

Neither the buyer nor the seller is diversif ied. Risk and returnmodels that focus on just the risk that cannot be diversified away willseriously underestimate the discount rates.

Key person value. There may be a significant personal componentto the value. In other words, the revenues and operating profit of thebusiness reflect not just the potential of the business but the presenceof the current owner.

The investment is illiquid. The buyer of the business will have tofactor in an illiquidity discount to estimate the value of the business.

Small Private Service Businesses


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S a a e Se ce us esses

Example: Valuing a Restaurant


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p g

You have been asked to value an upscale French restaurant for saleby the owner (who is also the chef). Both the restaurant and the chef

are well regarded, and business has been good for the last 3 years.

The potential buyer is a former investment banker, who tired of the ratrace, and has decided to cash out all of his savings and use the entireamount to invest in the restaurant. He cant cook

You have access to the financial statements for the last 3 years for therestaurant. In the most recent year, the restaurant reported $1.2M inrevenues and $400,000 in pre-tax operating income. While the firm

has no conventional debt outstanding, it has a lease commitment of$120,000 each year for the next 12 years.

Historical Financial Statements


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2011 2012 2013

Revenues $800 $1,100 $1,200 Operating at ~100% capacity

- Operating lease expense $120 $120 $120 12 years left on lease

- Salaries $180 $200 $200 Owner-chef is not paid salary

- Material $200 $275 $300 25% of revenues

- Other operating expenses $120 $165 $180 15% of revenues

= Operating income $180 $340 $400- Taxes $72 $136 $160 40% tax rate

= Net income $108 $204 $240

i) Discount Rates


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)

Recall that conventional risk and return models in finance, e.g., theCAPM, are built on the assumption that the marginal investors in

the company are well-diversified and that they therefore only careabout the risk that cannot be diversified away. That risk is oftenmeasured with beta(s), estimated by looking at historical stockreturns for the company.

In this private company valuation, both assumptions are violated.

Beta


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Accounting beta? Problems are that i) earnings are only measured once a year so require

many years of data and ii) earnings may be managed.

Fundamental beta? Beta as function of: ROE, Fixed Assets / Total Assets, BV of Debt / (BV

of Debt + BV of Equity), Expected Annual Growth in Net Income over 5

Years, Effective Tax Rate.

Predicted fundamental beta. Oneproblem is that R-squared is


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The average unlevered beta across 75 publicly traded restaurants inthe U.S. is 0.86. Problem: Most publicly traded restaurants are fast-

food chains (e.g., McDonalds, KFC).

There is an argument to be made that the beta for an upscale Frenchrestaurant is more likely to reflect high-end specialty retailers (e.g.,Saks Fifth Avenue, Tiffanys) than it is restaurants. The average

unlevered beta for 45 publicly traded high-end retailers is 1.18.

Adjusting for Non-Diversification Total Beta


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Estimating Total Beta


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Unlevered Total Beta == Unlevered Market Beta (CAPM) / Correlation with Market.

To go from market beta to total beta, we require a measure of howmuch of the risk in the firm comes from the market and how much isfirm-specific.

From the regressions of publicly traded firms that yield the bottom-upbeta should provide an answer: The average R-squared across the high-end retailer regressions is 25%. Because betas are based on standard deviations, we take the correlation

coefficient (the square root of the R-squared) as our measure of the

proportion of the risk that is market risk.

Unlevered Total Beta= Unlevered Market Beta (CAPM) / Correlation with Market

= 1.18 / 0.25 = 2.36.

Example: Market Beta or Total Beta?


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Valuing a company for sale to an individual or private business?

Valuing a company for sale to a public firm?

Valuing a company for sale to a private equity (PE) fund?

Valuing a privately owned company for an IPO?

Cost of Equity


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We will assume that this private restaurant will have a debt to equity(D/E) ratio (14.33%) similar to the average publicly traded restauranteven though we used retailers to the unlevered beta.

Levered total beta = 2.36 (1 + (1-0.4) x 14.33%) = 2.56.

Cost of equity = 3.0% + 2.56 x 5.0% = 15.81%.

Cost of Debt


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While the firm does not have a rating or any recent bank loans to useas reference, it does have a reported operating income and leaseexpenses (treated as interest expenses):

ICR = EBIT / Interest (Lease) Expense = 400,000 / 120,000 = 3.33.

Rating based on ICR = BB+. Default spread = 3.00%.

After-tax Cost of Debt = (Risk-free rate + Default spread) x (1 TaxRate) = (3.00% + 3.00%) x (1 - 0.40) = 3.60%.

WACC


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To compute the WACC, we will use the same industry average debtratio that we used to lever the betas:

Cost of capital = 15.81% (100/114.33) + 3.60% (14.33/114.33) =14.28%.

ii) Adjust Financial Statements


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2011 2012 2013 2013 Adjust

Revenues $800 $1,100 $1,200 $1,200

- Operating lease expense $120 $120 $120 $0 Leases are financial expenses

- Salaries $180 $200 $200 $350 Chef cost $150 / year

- Material $200 $275 $300 $300

- Other operating expenses $120 $165 $180 $180= Operating income $180 $340 $400 $370

- Interest expenses $60 6% x $1,006 = PV of $120 for 12 years @ 6%

- Taxes $72 $136 $160 $124

= Net income $108 $204 $240 $186

Year Lease PV (Lease)1 120 $113.21

2 120 $106.80

3 120 $100.75

4 120 $95.05

5 120 $89.67

6 120 $84.60

7 120 $79.81

8 120 $75.29

9 120 $71.03

10 120 $67.01

11 120 $63.21

12 120 $59.64

$1,006.06

Growth & Terminal Value


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Firms own past historical growth: Use with even more cautionbecause accounting standards are more loose (e.g., no GAAP).

Experts growth estimates: No equity research analyst reports. Use managements projections with even more caution because of bias

if they are selling the firm

Fundamental growth: Assume a 2% growth rate and a 20% ROC. Reinvestment rate = 10%.

Transition from one owner/CEO is much more complicated and may

not be successful so may have to liquidate the firm instead. Truncation risk?

iii) Key Person Value


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Attempt to separately value the company i) with and ii) without thekey person built into cash flows. Key person value.

Size is completely dependent on specific firm and circumstances.

The key person value is even larger if the key person starts acompeting business. May be reduced with non-compete and

non-solicitation contracts.

Examples: i) Buy restaurant from celebrity chef. What if he leaves?What if he leaves and starts a competing restaurant? Non-compete clause. ii) Buy doctors practice from retiring doctor.What if patients came for that specific doctor? Key personstays onboard for some years.

Adjusting Cash Flows


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It is possible that if the current owner/chef sells and moves on, therewill be a drop off in revenues. If you are buying the restaurant, youshould consider this drop off when valuing the restaurant.

If 20% of the patrons come to the restaurant because of the chef,the expected operating income will be lower if the chef leaves. Operating income (current chef) = $370,000

Operating income (also adjusted for chef departure) = $296,000

Relevant Also in Public Firms


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In 2011, Steve Jobs announced that he was stepping down as CEO ofApple. The stock lost $30B in market value on the announcement.

Valuation


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Inputs: Adjusted EBIT = $296,000 Tax rate = 40%

Reinvestment rate = 10% WACC = 14.27% Growth = 2%

Enterprise Value = FCFF / (WACC g) = Expected EBIT (1 Taxrate) (1 RIR) / (WACC g) = 296,000 (1.02) (1 0.4) (1 0.10) /(0.1428 0.02) = $1.328M.

Value of Equity = $1.328M $1.006M (PV of leases) = $ 0.323M.


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Value of Liquidity

What is Illiquidity?


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The cost of buyers remorse: It is the cost of reversing aninvestment after you made it.

Defined this way, all assets are illiquid. The difference is acontinuum, where some assets are more illiquid than others.

The idea that public firms are liquid and private businesses are notis overly simplistic!

Determinants of Illiquidity


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Macroeconomic conditions.

Liquidity of the assets owned by the firm.

Financial conditions of the firm.

Size of the firm.

Length of investment period.

Possibility of going public in the future.

Empirical Evidence


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In private company valuation, the illiquidity discount is a topic thatanalysts constantly debate

Despite all the discussion, seems to result in a simple rule of thumb:The discount for a private firm is 20-30% and does not vary muchacross different private firms.

Can we improve?

1) Restricted Stock Studies


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Securities issued by a company, but not registered with theSecurities and Exchange Commission (SEC), that can be soldthrough private placements, but cannot be resold in the open stockmarket for some time.

Studies: 20-30% discount.

Problems: Small samples, and private equity investors may provideservices to the firm for which the discount is compensation.

Estimating Illiquidity Discount


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Research study developed the following relation between the sizeof the restricted stock discount and the characteristics of the firm:

Estimating Illiquidity Discount


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2) IPO Studies


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Discounts on private placements prior to public offerings, relative tothe post-IPO price.

Studies: 45-50% discount.

Problems:

Very large discounts! Not arms length?

(family & friends)

Biased Samples


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With both the Restricted Stock and the IPO studies, there is asignificant sampling bias problem.

The companies that make restricted stock offerings are likely to besmall, financially distressed firms that have run out of conventionalfinancing options.

The IPOs where equity investors sell their stake in the five months priorto the IPO at a large discount are likely to be IPOs that have significantuncertainty associated with them.

One study concluded that the illiquidity alone accounted for adiscount of only


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All traded companies are illiquid!

We can regress the bid-ask spread (as a percent of the price) againstvariables that can be measured for a private firm.

Spread = 0.145 0.0022 ln (Annual Revenues) 0.015 (DERN) 0.016

(Cash / Firm Value) 0.11 ($ Monthly Trading Volume / Firm Value).

You could plug in the values for a private firm into this regression (withzero trading volume) and estimate the predicted spread for the firm.

Example: Restaurant


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Fixed discount: 25% $0.321 (1 0.25) = $0.241M.

Adjust for revenue and profitability: $0.321 (1 0.2875) = $0.229M.

Bid-ask spread regression: = 0.145 0.0022 ln (1.2) 0.015 (1) 0.016(0.05) 0.11 (0) = 12.88% $0.321 (1 0.1288) = $0.280M.

Public to Private Transaction:

What is Different?


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What is Different? The key difference between this scenario and a private to private

transaction is that the seller of the business is not diversified but thebuyer is or at least the investors in the buyer are. Consequently,

they can look at the same firm and see very different amounts of riskin the company with the seller seeing more risk than the buyer.

The cash flows may also be affected by the fact that the tax rates for

publicly traded companies can diverge from those of private owners.

There should be no illiquidity discount to a public buyer becauseinvestors in the public buyer can sell their holdings in a market.

WACC Comparison:

Private vs. Public Buyer of Restaurant


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y

Private Public

Unlevered beta 2.36 1.18D/E 14.33% 14.33%

Tax rate 40.00% 40.00%

Pre-tax cost of debt 6.00% 6.00%

Levered beta 2.56 1.28

Risk-free rate 3.00% 3.00%

ERP 5.00% 5.00%

Cost of equity 15.81% 9.41%

After-tax cost of debt 3.60% 3.60%

WACC 14.28% 8.68%

Equity Comparison:

Private vs. Public Buyer of Restaurant


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y

Private Public

Adjusted EBIT $370.00 $370.00

Key person discount 20.00% 20.00%EBIT $296.00 $296.00

Growth 2.00% 2.00%

Reinvestment rate 10.00% 10.00%

FCFF Year +1 $163.04 $163.04

WACC 14.28% 8.68%EV $1,327.27 $2,440.89

Debt $1,006.06 $1,006.06

Equity $321.21 $1,434.83

Liquidity discount 12.88% 0.00%

Equity $279.84 $1,434.83

So What Price to Ask For?


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Assume that you represent the owner/chef of the restaurant and thatyou were asking for a reasonable price for the restaurant. Whatwould you ask for?

$280,000

$1.43M

Some other number

If it is some other number, what will determine what you willultimately get for your business?

Rolling Up Private Businesses in Public Company


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pricing companies and m&a - s3

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