Monday, March 31, 2014

Getting Real: Real Options and M&A

Facebook is at it again. Following up on their February Whatsapp announcement- they now plan on a $2B purchase of Oculus. This new transaction is even more difficult to justify using traditional valuation methods as Oculus is an early stage virtual reality firm with no customers or revenues. It is tempting to write it off as an unjustified irrational bubble. In fact, the initial market reaction was negative. Alternatively, the problem may be with the traditional Discounted Cash Flow (DCF) methodology used to value Oculus and other early stage firms. 

DCF was designed for mature assets with identifiable bond like cash flows from an installed asset base. Growth can be considered in the relatively short forecast period before it decays into a steady state terminal value. It is less well suited for evaluating the entry and exploitation of attractive new markets thru the acquisition of rapidly growing targets. In these instances, cash flows from installed assets, often negative, are of secondary importance. The real value is in the follow-on growth investments. Failure to consider this fact under values the target.

DCF views targets as independent projects based on passively managed identifiable cash flows. It ignores the sequential interdependence among projects, and management’s ability to revise the investment profile so as to increase value. It is like trying to value a convertible bond focusing only on the coupon while ignoring its option value. Real Option Valuation (ROV) provides a means of thinking about the alternative supplemental option value sources, and helps close the gap between strategy and finance.  The gap is illustrated as follows:

1) Financial analysis is frequently overridden for strategic reasons
2) Strategic considerations such as diversification at the firm level are ignored by finance
3) Overvaluation based on DCF methodology is deemed irrational. Markets and managers may, however, recognize hidden value
4) Uncertainty increases option value unlike in DCF where uncertainty reduces value
5) Option like investments have a time value even if their intrinsic value is zero (i.e. out of the money)
6) Bastardized DCF methods like the Venture Capital Method way of evaluating start-ups which relies on ad hoc high discount rates to evaluate uncertain cash flows
7) Questionable synergies-synergies can be viewed as a crude ROV
ROV is best limited to smaller private targets with limited comparables. Value for these firms depends more on future market developments and management’s reaction to them not existing operations. They have a small chance of large payoffs (i.e. right skewed distributions with winner take all characteristics). Frequently missed is management’s ability to actively manage the target after the acquisition to change its value from the following actions:

1) Delay further investments while it moves up the learning curve. Competition can, however, reduce the option value of waiting in the fast changing tech world.
2) Scale back investments should growth slow
3) Expand investments if growth accelerates
4) Abandonment or put options to truncate losses if the market fails to materialize
Care is needed when dealing with ROV as it can used, just like DCF, to justify overpaying. Some investors are wondering if Facebook’s acquisition spree, which could be viewed as a complement to internal R&D, is beginning to look like Hewlett Packard.Thus, it should be used to supplement not replace DCF only in narrow circumstances satisfying at least the following:

1) The option must be exclusive like a patent. If everyone has it then no one has it.
2) Make sure it is an option not just an opportunity. This means identifying the underlying asset and the payoff contingency
3) Limit to very early targets-more relevant for Facebook than General Motors
4) Management has the ability to exercise successfully the option
5) The option is not over priced
6) There is some rational expectation of future cash flow
If the only tool you have is a hammer, then everything looks like a nail. You now have another tool in your valuation toolbox. Chose and use wisely.


Thursday, March 27, 2014

"A Man Hears What He Wants to Hear and Disregards the Rest"

The title comes from lyrics to one of my favorite songs by my favorite singer-songwriter, The Boxer by Paul Simon.  It also describes the subject of today's post: confirmation bias and how it might relate to acquisitions.  "Confirmation bias" is the tendency to overweight evidence that supports our views.  No sooner do you read the definition than you think of the countless ways this could apply to mergers and acquisitions.

First and foremost, consider the CEO determined to grow the company.  A possible target opportunity is identified and before beginning the analysis, the CEO has a favorable view. Being prudent, he or she state, "But let's see what the numbers say."  The danger is that he or she will overweight evidence that supports a positive  position.  It doesn't take much manipulation to change a negative net present value to a positive result.

While the CEO is generally not the person doing the analysis, we all know that when mangement asks "How much is 2 + 2?" the safest answer is "How much do you want it to be?"  That kind of bias leads to disastrous acquisitions.   Synergies, often used to justify deals,  are easy to imagine and tougher to realize.  

Confirmation bias can also be related to the frequency illusion, the odd feeling that some new thing you have just learned about is suddenly catching your attention more far more than seems probable.  Frequency illusion is thought to occur because we all have selective attention.  There are often far more sensory inputs occuring than we can process.  Consequently, our mind focuses on some pattern of interest and records that, ignoring much of the rest.  The pattern of interest, is likely to be the recently learned 'new thing' or information that conforms to our hopes and expectations.  Each new occurrence of the item increases our belief that our analysis and ideas are correct.

The solution, in the case of mergers or in any business decision is to ruthlessly challenge all assumptions, to stress test all analyses, to encourage and nurture dissenting views and to be constantly aware of they types of biases that can distort our thinking.

(For other posts on behavioral bias, see Behavioral Biases in Acquisitions - The Anchoring Effect and Roll's Hubris Hypothesis and Behavioral Bias.)

All the best,


Monday, March 24, 2014

Bank M&A: He Who Hesitates Is Lost

Attached is a recent American Banker article. The idea is that M&A waves follow major legislative changes which change the rules of competition. The current changes, similar to those in the 1990s, have or will trigger consolidation waves, which is particularly well suited to M&A. Yet, bank M&A remains modest. One of the reasons for the weak volume is many bankers still believe M&A is a mug’s game. The problem with assuming all M&A is bad is it assumes managers are either stupid or under some collective behavioral cloud.

I admit I used to believe that as well. Ralph's Paper on the possible miss measurement of M&A gains forced me to re examine my position. Once the anticipation effects before the bid announcement are included, M&A starts to look better. Illustrating again that business men are sometimes smarter than academics believe, Ralph excluded.

The other aspect is over caution regarding a possible over priced deal has competitive consequences. Banking is undergoing a metamorphous. Banks refusing to participate will suffer. There will be no second place prizes.


Thursday, March 20, 2014

Behavioral Biases in Acquisitions - The Anchoring Effect

This post is one in a series where we continue to explore how behavioral biases can affect merger decisions.  Joe started this discussion over a year and a half ago in a post entitled, Behavioral Bias, the Hidden Risk in Mergers and Acquisitions.  For years, economists have assumed that men and women were rational in their decision making and that markets were efficient.  To quickly come to the defense of economists (because on my better days I resemble one), these assumptions are not necessarily in place because we thought they were true.  Rather, they present a meaningful standard for testing alternate hypotheses.  After all, I can explain virtually anything but just telling you the decision maker was irrational.  So too can I explain any movements in the stock market by simply throwing up my hands and declaring markets are inefficient.  There is not much value in those two statements.  

There is value in carefully documenting empirical regularities in decision making.  The advancements in the field of behavioral finance have occurred simultaneously with two phenomena: 1)  the growth of experimental economics where subjects are presented alternate choices  in a controlled setting and researchers are able to carefully measure and calibrate the tests and 2) an increased appreciation in the field of finance for the psychological sciences.  

The literature on behavioral biases has been voluminous in recent years and we can only hope to start the dialogue and acknowledge some of the issues in these short posts.   Today, I just want to talk a bit about one of these biases: anchoring.  

The anchoring effect occurs when we give too much weight to some value presented early in the decision making process.  Research shows that final values are influenced by this initial number, even if it is irrelevant.  An interesting article in by Edward Teach in (see CFO magazine, Avoiding Decision Traps) gives many excellent examples.  In one, researcher Dan Aerily asked his MBA students to write down the last two digits of their social security number. Subsequent to this, they bid on bottles of wine and boxes of chocolate.  Students whose SS numbers were higher placed bids that were 60 to 120 percent higher.  Obviously, one's SS number has no relation to the actual value of the item, yet it had a major influence in the bidding.  

In many cases the anchoring number is presented to us as with the list value of a car, or the stated value of an item at a department store.  When we purchased the item at a lower price we feel that we obtained a bargain.  In fact, the initial number may have been grossly overstated or irrelevant.  Similarly, when a bidding or target firm suggests an initial value an anchor is created, one that often influences the outcome.

The price at which we purchased a stock can create an anchor even though (except for tax purposes) that value is irrelevant today.  I don't feel good about the Apple stock I purchased at $700 and I might be irrationally reluctant to sell below that price even if the true value is less.  

Other times, investors will anchor at the recent 52 week high value of a stock or its book value even though these numbers can bear little resemblance to true value.  

The lesson is to be aware and wary of the anchoring phenomena and where possible estimate values on your own without initial regard to other estimates.  

We will continue with other observations.  

All the best,


Monday, March 17, 2014

Warren Buffett: Dividends and Acquisitions

Warren Buffett’s Berkshire Hathaway BRK is facing a dividend challenge from a small investor. The investor is seeking a resolution to be voted upon at BRK’s annual May meeting. The resolution calls for a regular dividend. BRK argues against the resolution on technical grounds stating the board already decides each year on shareholder distributions. To date BRK has not paid a dividend, although it has engaged in share repurchases when it considers its shares undervalued (defined as share price< 120% of intrinsic value).  Initially, it appears the investor may be right. Essentially, he argues as follows:
  1.  BRK’s share price has lagged the S&P 500 index for 5 years
  2.  Buffett admits having difficulty investing BRK’s huge cash flow and cash balances
  3.  BRK is “elephant hunting”-looking for big deals
  4.  The elephant hunting may result in forced errors
  5.  Investors could better use the funds if they were return to them via dividends as repurchases would be ill advised at BRK’s current share price
Sounds like an approach used by activists like Carl Icahn against similar large firms with excess cash (e.g. Apple).

Buffett correctly points out dividends do not directly affect shareholder value. Dividends merely distribute value-they do not create value. What matters is who can invest the funds better-the firm or the shareholder. If the firm can do so thru organic or acquisition investments then it should retain the funds and make the appropriate capital allocations. Otherwise, the funds should be returned to shareholders. The decision rule is to retain and invest provided the expected returns exceed the cost of capital. The Dividend Discount Model shows Share Price=Dividend/ (Cost of Equity-Growth) where Growth= (1-Dividend Payout Ratio) x Return on New Investment. If investors need cash, then a better alternative, which may be more tax efficient, is for them to create homemade dividends by selling some of their shares.

Buffett’s record demonstrates good long term capital allocation decisions-albeit the last 5 years have been more problematic. Buffett, unlike the firms Icahn targets, eats his own cooking. Thus, the risks of value destructive capital misallocations from Agency Costs are reduced. BRK is more like long only hedge fund than a traditional maturing firm continuing to invest in declining projects. BRK can chose from a number of undervalued opportunities. I remember the last time Buffett was attacked as losing his touch in the 1990s with the tech boom. He was subsequently proven right.

I would trust Buffett for now to continue make good investment decisions. The dividend decision can be reconsidered should that trust turn out to be misplaced. For now, advantage Buffett.


Thursday, March 13, 2014

Rolls Hubris Hypothesis and Acquiring Firm Returns

I've heard management professors and some consultants throw around comments like "Seventy percent of all acquisitions fail."  I don't believe it and the statistical evidence doesn't support that claim.  True, there is a lot of evidence that suggests bidders break even or lose a few percent at the announcement of a bid.   The combined returns to bidders and targets, appropriately weighted for size, are positive.  The typical deal creates value.   What I might believe is that 70 percent (or more) of mergers fail to realize their potential.  But that is typically a problem of integration and the subject of other posts. 

So what do we make of the continuing story that bidders tend to lose or break even?  After all, bidding activity continues to be quite popular (even if currently dampened).   There are many explanations in the literature to explain bidder returns.  Today, I will mention two.

The first is the possibility that we, as researchers, are not measuring returns correctly.  In a recent paper published in the Review of Financial Studies we present evidence that the typically measured bidder return doesn't adjust for anticipation.   When returns are measured correctly bidder returns are positive.  See (Anticipation, Acquisitions and Bidder Returns.)  

But let's return to the fact that some deals, however measured, do result in the loss of value to the acquiring firm.  Even in our sample this occurs as much as 40% of the time.  Why? A good place to start looking for the answer is in the price paid for the target.  As we have noted, Every deal is a bad deal at some price.  Not every deal is a good deal at some price.

In an efficient market, the value of a firm's shares are priced correctly.  Why would bidders typically add 20-40% to the market price in their bids?  Why would bidders pay more than this? The obvious, and always cited reason is synergies.  Synergies, of course, can be easily overestimated and in other posts we note that you should always challenge the assumption of synergies.  Why are they available to your firm and to no one else?  

Another reason to explain high bid prices is behavioral - the hubris factor. Roll (1986) was the first to point this out in the finance literature.  

Anyone who has bid for an object on Ebay understands that it is easy to overpay, to go beyond the rational limits we might set in advance on our bids.  We get caught up in deal fever or a desire to 'win' regardless of price.  The same behavior must certainly be true of at least some acquiring managments.  One can imagine the psychological pressures on management in certain bidding wars.  Multiple sides express multiple views with many unkind words and suggestions.  If psychological factors lead bidders to go beyond pre-determined boundaries (or equivalently if management directly or indirectly causes their own analysts to overestimate the gains to mergers in setting those boundaries) shareholders lose.  As we have noted, some of the best deals are those not attempted or in this case, not completed.  

One of the best illustrations of the hubris phenomena are found in the words of Warren Buffett, quoted in a previous post,

"Many managers were apparently over-exposed in impressionable childhood years to the
story in which the imprisoned, handsome prince is released from the toad's body by a kiss
from the beautiful princess.  Consequently, they are certain that the managerial kiss will
do wonders for the profitability of the target company.  Such optimism is essential.
Absent that rosy view, why else should the shareholders of company A want to own an
interest in B at a takeover cost that is two times the market price they'd pay if they made
direct purchases on their own?  In other words investors can always buy toads at the
going price for toads.  If investors instead bankroll princesses who wish to pay double
for the right to kiss the toad, those kisses better pack some real dynamite. We've observed
many kisses, but very few miracles.  Nevertheless, many managerial princesses remain
serenely confident about the future potency of their kisses, even after their corporate
backyards are knee-deep in unresponsive toads." 

(Warren Buffett in the 1981  Berkshire Hathaway Annual Report)

We'll continue this discussion in two ways in the future.  One will be through an analysis of other factors related to bid premia and to bidding and acquiring returns.  A second avenue of analysis will continue to explore the role of behavioral factors in mergers and acquisitions.

All the best,


Monday, March 10, 2014

Enterprise Value Lending: Valuation and Credit Risk

A banker recently asked me a question regarding the use of projected cash flows for debt service. The question was whether the projected free cash flows, EBIT x (1-tax rate) + Depreciation-(Capital Expenditures + Working Capital Increases), could be used to estimate the implied market value of a firm’s assets. The answer is yes.

Banks use cash flow projections to gauge default risk. They also use historical book value balance sheet equity to estimate possible loss in the event of a default (LIED) if the firm is liquidated or reorganized. The problem with historical book value is it measures money spent, not current value. This is important for distressed firms whose value at the time of distress can be different from what was spent due to adverse economic, industry or management developments. Some investment expenditures may hold up better than others. This depends on whether the asset’s value is independent or dependent on the firm as a going concern. Assets which are largely independent of the firm’s continued existence like real estate hold the value more than those which are dependent on the firm existence like intangibles.

The projected cash flows, both base case and the downside, can be used to determine the implied enterprise value of their debtor. If after capitalizing the base case at reasonable costs of capital and growth, the value substantially exceeds the debtor’s current market or comparable trading value, then the projections are probably over optimistic. My preference is to the Adjusted Present Value approach instead of the Weighted Average Cost of Capital. This is to isolate possible leverage and tax distortions.

The downside projections provide estimates of distressed asset value. This provides a better estimate of LIED than traditional historical book value measures. This measure can be seen as a proxy mark-to market asset value. Provided enough value remains to cover the lender’s claims, then the bank can be repaid either thru a refinancing or sale of the debtor should it wishes to exit. Usually, lenders rely on enterprise value as a secondary repayment source. They try to limit their exposure to a discount of the downside value similar to the advance rate on an asset based loan (ABL). Unlike ABLs, no mechanism exists to modify the advance rate should conditions change-absent financial covenants.

Regulators recognize enterprise value as an alternative supplemental repayment source provided:
1)   Enterprise value is validated independent of the loan origination function.
2)   Sound consistent methodology is used. They favor the discounted cash flow approach over the multiple of EBITDA method.
3)   Estimates of a range of plausible stress scenarios versus a single point estimate are used.
4)   The estimates are periodically updated to reflect changing conditions.

Valuation provides the best measure of a firm’s debt capacity and its credit risk.


Thursday, March 6, 2014

Share Repurchase, Executive Options and Wealth Changes to Stockholders and Bondholders

There are many theories explaining the pros and cons of share repurchase.  Joe and I have debated many of these points in a series of four posts (to see the links to all of these see Repurchases: Part 4 - Some Concluding Comments).  One theory is that share repurchases signal positive information.  Another theory suggests repurchases transfer wealth from bondholders to shareholders because repurchases erode the equity base and increase risk to debt.  

Previous research is generally supportive of positive signaling but inconclusive with regard to wealth transfer.  Part of the problem with testing the wealth transfer hypothesis is that all bond repurchases are not alike.   In a very interesting article Kathy Kahle notes that the purpose of many share repurchases is to support executive options and that it is important to disentangle these effects when testing various hypotheses. (See When a Buyback Isn't a Buyback.) We utilize this result in a more refined test of the signaling and wealth transfer hypotheses that was published in the Journal of Corporate Finance in 2009.  The abstract and download information is below.

Share Repurchase, Executive Options and Wealth Changes to Stockholders and Bondholders

Sang-Gyung Jun 
Hanyang University 

Mookwon Jung 
Kookmin University 

Ralph A. Walkling 
Drexel University - Lebow College of Business 

We test the signaling and wealth transfer hypotheses around the announcement of share repurchases using a recent and larger sample of data than previously examined while employing a methodology designed to enhance the power of our tests. Disentangling the wealth transfer and signaling hypotheses is difficult; they are not mutually exclusive and can have opposite effects for bondholders. Wealth transfers will decrease bondholder wealth while positive signals will increase it; the combined effects obscure tests of each hypothesis. By focusing on sub-samples where signaling is more and less likely to be present we increase our ability to isolate the separate effects. In addition to traditional tests of wealth effects, we feature information inherent in the relation of wealth changes to equity and debt. Also, it is important to examine more recent evidence surrounding repurchases, particularly for bondholders. Most work on wealth changes to bondholders ends in 1997 with the demise with the Lehman Brothers Bond Database. Our results are generally consistent with the positive signaling effect of stock repurchases, but also provide some support for wealth transfer. Our work also emphasizes the importance of trying to disentangle the various hypotheses. In the subset of option funding repurchases, where signaling effects are less likely, the positive correlation of wealth changes between stockholders and bondholders is completely eliminated. Bond ratings are much more likely to be upgraded in samples without executive options which is precisely where the signaling effects are expected to be concentrated. Governance factors are insignificant.

Click here to find the final version of the article  or here to download a free, slightly earlier version.

All the best,


Monday, March 3, 2014

Facebook-Whatsapp $19B Acquisition: Dotcom 2.0?

Facebook is acquiring WhatsApp  for $19B of which $15B is in stock. Reaction rages from skepticism-repeat of the 1990s dotcom bubble-to euphoria as a brilliant move. Here are some facts:
  1. WhatsApp is a 4 year old firm with 55 employees. It has 450 mln users. If they pay $1 each it will generate sales of $450 mln in 2014.Thus, Facebook is paying a price to sale multiple of over 40 based on trailing number of users.
  2. The $19B price exceeds the market value of such well known names as Xerox ($13B) and Nordstrom ($11B).
  3. WhatsApp had an implied venture capital value of $1.5B in July, 2013.
  4. Google was allegedly prepared to offer $10B for WhatsApp.
  5. Facebook has a market value of $170B. The market reacted favorably to announced transaction.
  6. Facebook has a price earnings ratio of 55 compared to 23 and 14 for Google and Microsoft respectively.
  7. The previous Internet deals exceeding $10B in market value flopped-the biggest being the Time Warner AOL deal.
  8. Internet firms have an average life of around 11 years. Thus, Facebook is middle aged.

I understand the difficulty applying traditional valuation techniques like comparable and discounted cash flow to rapidly growing technology based firms. Nonetheless, I continue to rely on the following bedrock principles:
  1. Value is an opinion about what you may receive in the future. Price is a fact you pay for now.
  2. At some price even an excellent firm becomes a bad investment.
  3. Evaluate companies not industries.
  4. Beware of cash flow proxy measures like price per user. Eventually, they must tie back to cash.
  5. Access the Real Option Value of high growth investments, but be careful and make sure they are options and not just hopes or beliefs.
  6. Estimate the performance need to justify the price and determine whether it can be realistically obtained within a reasonable time period.
  7. Using stock as the primary form of consideration can help mitigate the acquirer’s risk.
  8. Do not forget about time and present values-how long do we have to wait?

Let’s focus on # 6 for now and assume the following:
  1. We can value WhatsApp at Facebook’s current Price earnings ratio of 55 in 5 years
  2. This implies breakeven profits of $363 MLN are needed in 2019.
  3. Assume a 20% net income margin.
  4. Required revenues of $1.8B are needed in 2019.
  5. The users required to generate that revenue are around 1.8B compared with current 450 MLN users-about 280 MLN new users p.a. are required.
We have ignored the 5 year time lag, ability to scale up and grow that fast and the impact of competitors and new technology on margins. This is of course just one, and a favorable one at that, of many possible scenarios.

The above indicates that while difficult-it is possible the deal could work financially. Facebook’s use of its potentially overvalued stock for over 75% of the purchase price helps cushion the downside. This is similar to what happened to AOL in the Time Warner transaction. Finally the WhatsApp acquisition could be viewed as a defensive or pre emptive transaction to keep Google, Facebook’s arch competitor, at bay. In M&A there are two different types of errors. The first is a type I error in making an over priced acquisition. There is also, however, a type II error from not making a good purchase and suffering possible adverse competitive consequences. The short average internet firm life span of 11 years suggests the cost of inaction - a type II error- outweighs the risk of a type I error.

I am not trying to justify the transaction. Rather, I am trying to understand it. It is a big bet for high stakes. It will be interesting to see how it plays out.