Acquisition Finance: Creating Value

Joe and I will be teaching our Acquisition Finance Course in Amsterdam in less than two months.  One of the things we start with in the course is identifying ways in which Acquisition Finance creates value.  I can't cover all of these in a short blog post but I'll try to outline some of the concepts and ideas.

Acquisition finance involves some change in the capitalization of a company.  That is, some change in the way it is financed.  It can occur as a result of a sale of the company to new owners or a recapitalization of the company under the existing owners.  In the case of an LBO or MBO, management is often part of the buyout team.  It is also common for the new financial structure to involve high amounts of leverage, hence the term LBO or HLT (highly levered transactions).

In an earlier post, we discuss 5 Ways that Acquisition Finance Creates Value, including

1. Improving incentives
2. Improving efficiency
3. Improving governance
4. Reducing regulatory requirements
5. Creating tax shields

As we have also noted, highly leveraged transactions increase risk (see Six Disadvantages of Highly Levered Firms).  And see Joe's recent column where he notes that just because you can do something, doesn't mean you should!  (See Leveraged Acquisition Loans: Fasten Your Seat Belts.) The art of the deal is finding the right balance, measuring the rewards of acquisition finance against the risks.  The following slide conveys the idea, considering just one of the advantages of high leverage, tax shields.

Increased leverage increases a firm's interest expense.  Since interest is deductible for tax purposes, this results in an annual tax savings.  The capitalized value of this tax savings increases a firm's market value, a positive.   But increased leverage also increases risk - a negative in terms of firm value.  And so the net impact must be carefully considered.  In future blogs, and certainly in our course, we'll discuss more of the specifics:  with tax shields this includes how to evaluate the level of risk, how to capitalize the value of the tax shields, how increased leverage directly impacts a firm's beta coefficient (and hence the required rate of return) and why discount rates are likely to change over time in the typical HLT.

All the best,

Ralph

Carl Icahn’s Apple Tweet and Shareholder Activists

Carl Icahn’s short Tweet about his 9/30/13 dinner meeting with Apple’s CEO Tim Cook seems to have triggered some angry reaction by some commentators (see Tweet). In his Tweet, Icahn stated Apple should consider using its $ 150B+ cash hoard to buy back its undervalued stock. Some commentators are incensed that, although he is a major shareholder, he could call into question the use of Apple’s cash, or worse yet, demand its return to shareholders. I guess they believe that shareholders, like children, should be seen, but not heard.

Earlier this year Apple, prodded by another activist - David Einhorn, agreed to a major debt financed stock repurchase and dividend program (see Dividend). Nevertheless, Apple’s cash continues to grow. Apple, however, appears to be transitioning from a rapidly growing technology firm to a maturing consumer electronics company. This change is difficult for Apple’s senior management and many commentators to accept.

Companies experiencing life cycle changes find it difficult to accept change and cling to the hope they can regain their mojo. After-all, didn’t Steve Jobs accomplish this very feat 15 years ago? Unfortunately, the supply of Steve Jobs’ may be limited.

Activist investors like Icahn and Einhorn are concerned with the value destructive impact of firms failing to adapt. They are aware of Schumpeter’s creative destruction whereby firms are only king for a day (see Creative Destruction). Furthermore, they are especially concerned with Jensen’s free cash flow (see Warning). Jensen highlighted the excess cash flow leads to empire building. Consequently, financial policies like maintaining large cash balances that may have been appropriate for the younger Apple may no longer be appropriate. Evidence indicates that activist shareholders, bringing up inconvenient truths, have a positive impact on maturing firms by forcing them to disgorge cash instead of wasting it on misguided growth.

Companies like Apple should consider aggressive changes in their financial policy including increased dividends and debt financed share repurchases at the right price. Managers may dislike shrinking their kingdom even though such action makes their citizen shareholders richer. They, along with populist commentators, want a return to the past instead of realistically facing the future. They frequently allege the activists are destroying a great franchise. What they miss, however, is the return cash can be invested by investors in new Apples rather than trapped in the old lemons.

The capital markets are not museums to preserve once great companies - well at least for everyone but the French. The capital markets are complex adaptive systems in which firms are born, grow and are replaced. That is the key for a dynamic economy, and the efficient allocation of capital.

We may not like what the activists say or how they say it, but they provide a valuable catalytic function. Sorry for the rant.

J

PS Less than 2 months to Acquisition Finance in Amsterdam.  See the link here.

The Price is Right?

Ralph and I have previously mentioned the difference between price as a fact and value as an opinion.  (See, for example, Value is Estimated, Price is Paid.)  Nonetheless, many remain rightfully confused by a firm whose stock is trading at $20 p/s receiving a takeover offer for $30 p/s.  Specifically, was the $20 price wrong or is the $30 offer a mistake? While it is possible for either the market price or offer to be wrong-it is also possible they are both right, but under different circumstances.

As an opinion, value is truly in the eyes of the beholder. Equally true, there is no one true intrinsic value based on a firm’s cash flows (magnitude and timing) and risk. Think of valuation as an attempt to price expected operating performance. This in turn depends on the firm’s market environment and the strategy and asset-liability combinations employed by management in the execution of their chosen strategy. Thus, different owner-manager teams can different results from the same firm.

Changes in the industry environment from technology and regulation shifts for example can render existing strategies obsolete. Existing management may be unable or reluctant to change, thinking the changes to be cyclical not structural. Performance under these conditions starts to decline and the firm’s stock price begins to decline as passive minority shareholders begin to vote with their feet by selling their shares. These selling shareholders have priced downward from say $30 p/s to $20 the firm’s expected operating performance based on its current strategies in a changed market. They no longer share management’s expectations.

The price decline attracts the attention of others who see profit opportunities from shifting to alternative higher value strategies, asset -liability combinations and improved management execution of the strategies. These investors are active control shareholders seeking to force a change. This in turn requires a significant ownership position or majority to implement their plans. These investors are prepared to obtain this position by offering a premium to existing shareholders of $30.  Their price is not based on the firm’s expected operating performance as currently configured. Rather, it reflects their view of operating performance under a new higher value strategy and management team.

This illustrates that firms trade in two different financial markets, and at two different prices. The first represents the passive minority interest market, for example, the firm’s current Bloomberg terminal price, based on existing strategies and management. The other is a potentially higher price to alternative owners employing different strategies and management; this price is available in the market for corporate control. Of course, the new investors can be wrong. They are, however, willing to back up their beliefs with real capital. Thus, their position can have more credibility than a simple existing management denial – a management who may be more interested in keeping their jobs than in creating shareholder value.

So next time before assuming the share price is right first make sure you specify which price you mean. The right price depends on the right combination of owners, strategies and management, and this combination changes over time.

J

Goodwill Hunting

Unlike the 1997 movie-this story does not have a happy ending. A January 30, 2013 Citi Credit Research note titled "The Goodwill Game" provides some interesting insights into the extent of recent M&A over-payments. Goodwill is the difference between the price paid and the book value of the assets acquired. It represents a proxy, albeit crude, for the premium paid by the acquirer. It is tested in subsequent years for an impairment charge if the value of the assets declines relative to their original carrying value. The valuation methods used are similar to those Ralph has previously outlined. (See, for example, Estimating Value, Part 1). Recent examples of substantial write-downs include HP's $8.8B charge on the Autonomy and Rio Tinto's $3.5B write-down on mining assets. Alarmingly, the report shows that goodwill growth is out-pacing total asset increases.

The write-downs highlight the importance of the three most important things in an acquisition: price, price and price. Over paying, as represented by goodwill, is the reason why most acquisitions fail to create value for the buyer's shareholders. Management often tries to explain write-downs as unimportant non-cash charges. The cash, however was lost when the over-priced acquisition was made. Furthermore, the write-down reduces managerial accountability for the remaining assets-the out-of-sight-out-of-mind effect. Post write-down, the future operating performance can actually appear to improve. Perhaps, we should consider keeping the investment's original value when determining performance reviews?

The problem is worse still for serial acquirers like HP who, while suffering from depressed share prices, continue to make over priced acquisitions to cover-up a declining business model. Shareholders tired of seeing the wealth wasted in high premium-high goodwill acquisitions should insist that Boards pressure management to stop the madness and return the capital to them via dividends. The kingdom may be smaller, but its citizens will be richer.

Investors should keep a close eye on the level of goodwill creation and write-downs as we continue into the earnings-10K season. It provides an insight into the quality of management and their acquisition proposals. It also raises questions concerning Board oversight and governance of the acquisition process.

j

Estimating Value: Part 4 Using Comparables in Valuation

Three previous posts have talked about methods of valuation, specifically  the use of discounted cash flow in valuation,  the use of multiples in valuation and the advantages and disadvantages of multiples.  We extend this series with a brief discussion of the Method of Comparables.  

Method of Comparables

If  data is available on firms similar to the one we are trying to value, this data can be used as benchmarks.  In fact, this reliance on comparable firms is at the heart of the multiple method discussed previously.  Here we are looking at the price to earnings, price to book, price to EBITDA or other multiples of comparable firms and trying to derive our own inferences.

Comparables are particularly useful in looking at actual completed transactions.  This method is often used in valuing residential property. In that case, the analyst gathers data on the recent sales of similar property (e.g., a four-bedroom split level house in a particular school district) and uses this average as a point of departure for valuing the property of interest. Subjective adjustments to this estimate are made depending upon perceived differences in the property of interest and the comparables. For example, the estimated value would be lowered if the property had less desirable curb appeal; values would be raised if the property had, say, an updated kitchen.

Similarly, a comparables analysis of a business starts by finding several firms whose value is known.  Given the objective information provided by these comparables, the analyst then makes subjective adjustments based on the differing characteristics between the comparable firms and the one to be valued.  

This type of analysis is particularly useful when we have a set of comparable firms that have recently been sold.  The strength of the comparable method with completed deals is that it relies on market transactions to establish a benchmark price.  The disadvantage is the difficulty in getting recent market data on a meaningful set of truly comparable firms.  Differences in industry, size, geographical location, and accounting techniques are among the difficulties in finding comparables. Moreover, accurate data on privately held companies is often difficult or impossible to obtain.

Finally, we again emphasize  the distinction between using transactions and non-transactions data.  Transactions data are ideal as they reflect selling price information on actual deals that have been completed.  However, adding this restraint to the matching criteria listed above usually severely restricts sample size.  Non-transactions data are also quite useful, but, of course don't reflect actual deals.  Thus, we're looking at a stated market price for our comparables, but not necessarily a price at which the firm would be sold.  Setting the latter value involves not a multitude of factors.  To mention just a few we must consider the strategy, motives and characteristics of the acquiring firm, the target, the way the deal is structured, the bargaining power of the parties, the availability of other bidders, and any premia for control or discount for illiquidity.  

In subsequent post, we'll talk more about control premia and liquidity discounts as well as about some sources of data for comparable transactions.

R

Estimating Value: Part 3 Advantages and Disadvantages of Multiples in Valuation

Two previous posts have talked about the use of discounted cash flow in valuation and the use of multiples in valuation.  At the end of the multiples post I promised to return to the advantages and disadvantages of multiples.  That is the subject of today's post.

Advantages and Disadvantages of Multiples in Valuation

 The main advantages of multiples are that they are relatively easy to use, are based on actual market transactions and can provide a useful ballpark for estimating value. It takes a known quantity for a firm like earnings or book value and converts it into a proposed price for the firm.  The problems associated with multiples are many, starting with the difficulty in finding comparable and timely comparisons.  The multiple approach also presumes that the prices paid for competing firms or their shares of stock were realistic in the first place!  Moreover, the average multiple for a set of transactions disguises the wide range of differences that can exist within a given industry. It is not unusual, for example, to observe an average multiple of 15 times earnings for an industry with a range from 10-20 times earnings representing actual transactions.  Selling your firm for the average of 15 times earnings when you could have received 20 times earning is obviously not maximizing shareholder value. 

To illustrate the wide range of multiples within various industries, consider the Table below taken from some work I developed using Value Line Investment Survey.  The table shows the mean, median and range of price earnings ratios for ten industries during the summer of 2001.  Of particular interest is the extreme range of the multiples within a given industry.  Note the ratio of the range shown in the far right column.  There are only two industries where the range in values from low to high is less than 50% of the median value; both of these industries involve just a handful of firms.  

Table 1: Range of price earnings ratios across industries
Name of Industry	# of Cos.	Mean	Low	Median	High	Ratio of range     (high – low) to median value
Aerospace/Defense	16	15.2	6.3	14.8	27.5	143%
Auto Parts Industry	17	17	8.4	14.7	30.2	149%
Bank Industry	30	17.9	13.2	16.7	32.2	114%
Beverage (soft drinks)	8	24.3	21.8	23.8	27.4	24%
Hotel/Gaming Industry	16	17.3	11.4	17.1	31.1	116%
Medical Services	28	18.8	6.3	19	29.6	123%
Newspaper Industry	13	31.1	19.1	30.3	48.6	98%
Petroleum (Producing)	9	12	7.7	10.6	24.2	156%
Retail Store Industry	20	20.9	7.5	21.1	43.3	170%
Tobacco Industry	6	11.3	8.8	11.3	13.4	41%
Source: Value Line Investment Survey – Issues from 7/6/01 through 9/28/01.

Consider the Auto Parts Industry.  The range is from a low of 8.4 to a high of 30.2.  Can you confidently price your company at any of these valuations (or the mean or the median) without more fine tuning?  I think not.  

Moreover, multiples are based on rules of thumb, often learned through the experience of practicioners.  But consider just a few of the factors affecting valuations: economic conditions, consumer tastes, the existence of war, technology, alternate products, complementary products, inflation, etc.  etc. The list could continue for quite some time.  As any of these factors change, so could the multiples.  Even the relative ordering of multiples within industries will change over time (inflation or the price of oil affects industries differently).  This set of multiples measured today would vary considerably.

Also remember the types of multiples shown in the use of multiples  [from Snowden (Table 1)].  In many cases, a range of multiples is provided and often, the range of multiples seems so large as to provide little help in estimating a firm’s value.  

Indeed, analysis of the multiples existing within any particular industry is likely to produce a very large range.  The analyst needs to make subjective adjustments recognizing differences between the firm of interest and the comparison set.  This involves recognizing the current and future earnings power of the companies, reflecting current market conditions, and identifying other important differences between the firm and the comparison set.  At the extreme, recognition of these differences leads to an analysis reminiscent of the detail inherent in a discounted cash flow approach.  

This is not to say that multiples are without merit.  On the contrary.  Multiples are just one other means of valuation with their own advantages and disadvantages.  They also serve as boundary checks on methods like discounted cash flow valuation.  Finally, many analysts that use discounted cash flow to value the next several years of earnings will still use multiples to estimate terminal values.

In the next valuation post, we'll conclude with a look at a related method of valuation: comparables.

Estimating Value: Part 2 Using Multiples

Following up on two previous posts, ( Value is Estimated, Price is Paid and Estimating Value: Part 1 DCF ) we begin a multiple post discussion of the use of multiples to estimate value.  We use multiples all the time in our daily lives.  As just a few examples consider driving:  miles per gallon, miles per hour, price per hour of parking.  Consider college: price per class,  price per credit hour, average price per book.  Consider housing: price per square foot (or meter), price per kilowatt hour (for heating).  Consider advertising: price per (internet) hit, price per name (for mailing lists), price per column inch (for print advertising).  Consumer products are standardized as price per unit (often an ounce, etc.)  And certainly our wages are expressed in multiples: salary per year, dollars per hour.

Multiples are pervasive.  So it should not be surprising that multiples are used in business valuation.  Note that in each example listed in the first paragraph, the multiple was expressed as a factor of a base (the item after per).  The base should be something meaningful to what we are estimating.  In business valuations, some common bases include: earnings, book value, EBITDA, sales, cash flow, growth, customers and other items.

In business valuations, we choose an appropriate multiple for our industry, find the relevant value for our company (by looking at the average or weighted average multiple of comparable companies), and apply the result to the appropriate base value for our company.

As an example, consider the price earnings ratio.  When we are buying a company (or a fraction of a company, i.e., a share of stock), we are essentially buying the future earnings stream of a company.  It makes sense to use earnings as a meaningful base from which to project price.  So let's say we estimate next years earnings for our firm to be $3. per share and we find a set of companies similar to ours with an average price earnings ratio of 10.  The implication is that our company is or will be worth $3 x 10 = $30. per share.

Similar calculations would be used for other bases (book value, sales, etc.)  In some cases one type of base is more meaningful for a particular industry.  In other cases, analysts might average several valuations resulting from various multiples or weight the valuations according to factors relevant in the particular situation.

A very partial list of some multiples used in practice include:

• Price to earnings
• Price to book value
• Price to sales
• Enterprise value (i.e., equity plus debt) to sales
• Price to EBIDTA

etc.

Practitioners have also evolved elaborate variations on strict multiples. (Note: I'm not commenting on the merits of these multiples here or the superiority or lack of it in the multiples listed below.  I will, however, discuss advantages and disadvantages of multiples in general in my next post.)   Consider a list of industry multiples provided by Snowden (1994) and shown in Table 1 below.  The items being multiplied vary by industry.  Many also include specific adjustments for inventory or equipment.

Table 1:               Industry Multipliers

Industry	Multiple
Travel agencies:	.05 to .1 X Annual Gross Sales
Advertising agencies:	.75 X Annual Gross Sales
Collection agencies:	.15 to .2 X Annual Collections + Equipment
Employment agencies:	.75 X Annual Gross Sales
Insurance agencies:	1 to 2 X Annual Renewal Commissions
Real estate agencies:	.2 to .3 X Annual Gross Commissions
Rental agencies:	.2 X Annual Net Profit + Inventory
Retail businesses:	.75 to 1.5 X Annual Net Profit + Inventory + Equipment
Sales businesses:	1 X Annual Net Profit
Fast food (nonfranchise):	.5 to .7 X Monthly Gross Sales + Inventory
Restaurants:	.3 to .5 X Annual Gross Sales, or .4 X Monthly Gross Sales + Inventory
Office supply distributors:	.5 X Monthly Gross Sales + Inventory
Newspapers:	.75 to 1.5 X Annual Gross Sales
Printers:	.4 to .5 X Annual Net Profit + Inventory + Equipment
Food distributors:	1 to 1.5 X Annual Net Profit + Inventory + Equipment
Building supply retailers:	.25 to .75 Annual Net Profit + Inventory + Equipment
Job shops:	.5 X Annual Gross Sales + Inventory
Manufacturing:	1.5 to 2.5 X Annual Net Profit + Inventory or  .75 X Annual Net Profit + Equipment + Inventory (including work in progress)
Farm/heavy equipment dealers	.5 X Annual Net Profit + Inventory+ Equipment
Boat/camper dealers:	1 X Annual Net Profit + Inventory + Equipment
Professional practices:	1 to 5 X Annual Net Profit

Source: The Complete Guide to Buying a Business, Richard W. Snowden AMACON, New York, 1994, pp. 150-151.

These were given at a particular point in time and learned from actual experience.  As you will learn in our next post, they are unlikely to be relevant today, but you can see variation in multiples suggested with various adjustments for different industries.  

From all of this detail you might assume I am a huge fan of using multiples in valuation.  I am not.  Don't get me wrong, multiples are an important part of our valuation toolkit, but they have distinct advantages and disadvantages.  It is important to understand these attributes before using multiples.  We'll cover that topic in Monday's blog.

All the best,

Ralph

Estimating value: Part 1 An Overview of Discounted Cash Flow

Previously, we've written that Value is estimated, Price is paid.  Today we  start to discuss some of the many ways to estimate value.  Each method has advantages and disadvantages.  None is perfect but taken together they provide a meaningful framework for estimating value.

Some of the major techniques used to estimate value include:

• Discounted cash flow
• Multiples
• Comparable Transactions

In today's post, I'll provide an overview of discounted cash flow, returning to multiples and comparable transactions at a later time.  We'll also ignore liquidation value and book value for this post.  Liquidation value is useful when you are anticipating dismantling a company and book value is, well, historic.  The book value of any asset doesn't necessarily reflect true value and is often dramatically different.  That said, there seems to be some  information in book value.  Multiples of book value, for example, are often used in valuation.

True or intrinsic value
So we mentioned 'true value'.  It is often called 'intrinsic' value, and yes, it exists in the eye of the estimator.  The true worth of an asset, of course, is what someone else will pay for it.  But in valuing our company this is unknown.  How can we get estimates of intrinsic value, estimates that inform a meaningful selling price?

DCF in practice
Let's start with discounted cash flow.  Simply put, the value of any business asset is the stream of cash flows it will generate throughout its life, expressed in today's dollars.  We generally assume that businesses, and the equity that represents ownership in these businesses have an infinite life.  Products follow a life cycle.  Companies that produce them can last indefinitely by continuing to adapt, replacing old products with new ones.  Now, we can't meaningfully think about cash flows at year seventeen, let alone at infinity so we often use a shorter term investment horizon.  Let's take five years and assume (probably artificially) that we sell the company or stock at the end of this period.  Whether we do is immaterial, it just helps us conceptualize the issue.

So in the diagram below we have two cash flow streams, one stretching to infinity and one truncated at five years.   The present value of each of these streams is the current worth of the company.

The equation describing the discounting process (converting the cash flows into today's values) is shown below.

Terminal value
Note that in the arrowed diagram and in the equation the cash flows stretching from year six to infinity are replaced by SP5, the terminal value.  This is the assumed selling price in year 5.  How do we estimate this selling price?   Two standard techniques are: a) a constant growth model and b) price multiples.  The first technique is a mathematical reduction of assuming cash flows will grow at a constant rate forever.  The second is based on the valuations of related companies.  Both methods have some merit.  I'll cover multiples in a separate post, but let me address an often voiced concern with assuming 'constant growth'.  Sure, no company is likely to actually have constant growth, but as we noted above, it becomes impossible to estimate growth precisely at some date in the future.  What is your estimate of growth in year 17 ??  Our choice is to either ignore the future or incorporate our best guess.  Constant growth does the latter.  Also, commonly used multiples (of earnings, book value, etc) have built-in but unstated assumptions just as heroic.  A word of caution: probably 70-90 percent of a firms value will occur after year five.  Be very  careful with that estimate.  

Advantages and disadvantages of DCF

An advantage of the discounted cash flow technique is that it can be applied to any business from purchasing a motel in Orlando to a photography store in Crested Butte to purchasing General Motors. In each of these examples, the value of the business to the owners is equal to the present value of all the distributions the business will generate. 

It is sometimes argued that discounted cash flow is difficult to understand.  To the contrary, the mechanics are easily applied using spreadsheets or financial calculators.  The intuition behind discounting is also easy to understand: money received in the future is worth less than money received today. The intuition behind the rate we use is also straightforward: We should discount cash flows at the appropriate opportunity cost. In other words, evaluate this project at the rate we could earn on projects of similar risk.  Our answer to the question: “What rate could we earn elsewhere with the money at this risk level?” answers the rate question.  And since higher discount rates (associated with riskier ventures) lower the present value this method adjusts for risks.

It is also asserted that the DCF method requires too many assumptions.  It is true that forecasting the amounts received in the future and estimating the opportunity cost of funds require challenging assumptions.  Nevertheless, all valuation methods utilize assumptions.  With some techniques, however, the assumptions are hidden in the apparent simplicity of the process.  As a consequence, users are often making implicit assumptions without even being aware of it.  A major advantage of discounted cash flow is that the assumptions can be quite explicit.  The ability to fine tune projections of cash flows to recognize individual firm characteristics is a tremendous advantage. Moreover, most alternatives to discounted cash flow, such as using ad hoc rules of thumb to value an asset, do not allow for easy updating. Rules of thumb that held in the past may quickly become obsolete if some underlying factor of the economy (e.g. inflation) changes. Discounted cash flow with its component parts expressed in a spreadsheet allows for immediate revisions.

In a subsequent post, we'll take a brief look at multiples and comparables.