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deal to acquiring stockholders. A ¬nancial analyst can use the following methods to as-
sess whether the acquiring ¬rm is overpaying for the target.


Analyzing Premium Offered to Target Stockholders
One popular way to assess whether the acquirer is overpaying for a target is to compare
the premium offered to target stockholders to premiums offered in similar transactions.
If the acquirer offers a relatively high premium, the analyst is typically led to conclude
that the transaction is less likely to create value for acquiring stockholders.
Premiums differ signi¬cantly for friendly and hostile acquisitions. Premiums tend to
be about 30 percent higher for hostile deals than for friendly offers, implying that hostile
acquirers are more likely to overpay for a target.7 There are several reasons for this. First,
a friendly acquirer has access to the internal records of the target, making it much less
likely that it will be surprised by hidden liabilities or problems once it has completed the
deal. In contrast, a hostile acquirer does not have this advantage in valuing the target and
is forced to make assumptions, which may later turn out to be false. Second, the delays
that typically accompany a hostile acquisition often provide opportunities for competing
bidders to make an offer for the target, leading to a bidding war.
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Comparing a target™s premium to values for similar types of transactions is straight-
forward to compute, but it has several practical problems. First, it is not obvious how to
de¬ne a comparable transaction. Figure 15-1 shows the mean and median premiums
paid for U.S. targets between 1989 and 1998 relative to stock prices one week prior to
the ¬rst acquisition announcement. Average premiums have been approximately 40 per-
cent and medians around 30 percent during this period. However, there is considerable
variation across transactions, making it dif¬cult to use these estimates as a benchmark.
A second problem in using premiums offered to target stockholders to assess whether
an acquirer overpaid is that measured premiums can be misleading if an offer is antici-
pated by investors. The stock price run-up for the target will then tend to make estimates
of the premium appear relatively low. This limitation can be partially offset by using tar-
get stock prices one month prior to the acquisition offer as the basis for calculating pre-
miums. However, in some cases offers may have been anticipated for even longer than
one month.
Finally, using target premiums to assess whether an acquirer overpaid ignores the
value of the target to the acquirer after the acquisition. This value can be viewed as:
Value of target after acquisition = Value as independent ¬rm + Value of merger
Value of target after acquisition = Value as independent ¬rm + bene¬ts
The value of the target before acquisition is the present value of the free cash ¬‚ows
for the target if it were to remain an independent entity. This is likely to be somewhat
different from the ¬rm™s stock price prior to any merger announcement, since the pre-
takeover price is a weighted average of the value of the ¬rm as an independent unit and
its value in the event of a takeover. The bene¬ts of the merger include such effects as
improvements in target operating performance from economies of scale, improved man-
agement, or tax bene¬ts, as well as any spillover bene¬ts to the acquirer from the acqui-
sition. Clearly, acquirers will be willing to pay higher premiums for targets which are
expected to generate higher merger bene¬ts. Thus, examining the premium alone cannot
determine whether the acquisition creates value for acquiring stockholders.

Figure 15-1 Premium Paid for Mergers and Acquisitions in the Period 1989
to 1998
0.5

Mean
0.4

Median
0.3

0.2

0.1

0
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
Source: Mergerstat , 1999.
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15-7 Part 3 Business Analysis and Valuation Applications




Analyzing Value of the Target to the Acquirer
A second and more reliable way of assessing whether the acquirer has overpaid for the
target is to compare the offer price to the estimated value of the target to the acquirer.
This latter value can be computed using the valuation techniques discussed in Chapters
11 and 12. The most popular methods of valuation used for mergers and acquisitions are
earnings multiples and discounted cash ¬‚ows. Since a comprehensive discussion of
these techniques is provided earlier in the book, we focus here on implementation issues
that arise for valuing targets in mergers and acquisitions. We recommend ¬rst computing
the value of the target as an independent ¬rm. This provides a way of checking whether
the valuation assumptions are reasonable, since for publicly listed targets we can com-
pare our estimate with premerger market prices. It also provides a useful benchmark for
thinking about how the target™s performance, and hence its value, is likely to change
once it is acquired.

EARNINGS MULTIPLES. To estimate the value of a target to an acquirer using earn-
ings multiples, we have to forecast earnings for the target and decide on an appropriate
earnings multiple.
Step One: Forecasting Earnings. Earnings forecasts are usually made by ¬rst fore-
casting next year™s net income for the target, assuming no acquisition. Historical sales
growth rates, gross margins, and average tax rates are useful in building a pro forma
income model. Once we have forecasted the income for the target prior to an acqui-
sition, we can incorporate into the pro forma model any improvements in earnings
performance that we expect to result from the acquisition. Performance improve-
ments can be modeled as:
• Higher operating margins through economies of scale in purchasing, or increased
market power;
• Reductions in expenses as a result of consolidating research and development
staffs, sales forces, and/or administration; or
• Lower average tax rates from taking advantage of operating tax loss carryforwards.
Forecasting earnings after acquisition requires some caution since, as we discuss lat-
er, an acquisition accounted for using purchase accounting will typically lead to in-
creased goodwill amortization and depreciation expenses for revalued assets after the
acquisition. These effects should be ignored in estimating future earnings for price-
earnings valuation.
Step Two: Determining Price-Earnings Multiple. How do we determine the earnings
multiple to be applied to our earnings forecasts? If the target ¬rm is listed, it may be
tempting to use the preacquisition price-earnings multiple to value postmerger earn-
ings. However, there are several limitations to this approach. First, for many targets,
earnings growth expectations are likely to change after a merger, implying that there
will be a difference between the pre- and postmerger price-earnings multiples. Post-
merger earnings should then be valued using a multiple for ¬rms with comparable
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Mergers and Acquisitions




growth and risk characteristics. (See discussion in Chapter 11.) A second problem is
that premerger price-earnings multiples are unavailable for unlisted targets. Once
again, it becomes necessary to decide which types of listed ¬rms are likely to be good
comparables. Finally, if a premerger price-earnings multiple is appropriate for valu-
ing postmerger earnings, care is required to ensure that the multiple is calculated pri-
or to any acquisition announcement, since the price will increase in anticipation of
the premium to be paid to target stockholders.
The following table summarizes how price-earnings multiples are used to value a tar-
get ¬rm before an acquisition (assuming it will remain an independent entity), and to
estimate the value of a target to a potential acquirer:

Summary of Price-Earnings Valuation for Targets
.........................................................................................................................
Value of target as an Target earnings forecast for the next year, assuming no change
independent ¬rm in ownership, multiplied by its premerger PE multiple.
Value of target to Target revised earnings forecast for the next year, incorporating
potential acquirer the effect of any operational changes made by the acquirer, mul-
tiplied by its postmerger PE multiple.
.........................................................................................................................


As explained in Chapter 11,
LIMITATIONS OF PRICE-EARNINGS VALUATION.
there are serious limitations to using earnings multiples for valuation. In addition to
these limitations, the method has several more that are speci¬c to merger valuations:
1. PE multiples assume that merger performance improvements come either from an
immediate increase in earnings or from an increase in earnings growth (and hence
an increase in the postmerger PE ratio). In reality, improvements and savings can
come in many forms”gradual increases in earnings from implementing new op-
erating policies, elimination of overinvestment, better management of working
capital, or paying out excess cash to stockholders. These types of improvements
are not naturally reflected in PE multiples.
2. PE models do not easily incorporate any spillover benefits from an acquisition for
the acquirer, since they focus on valuing the earnings of the target.

DISCOUNTED CASH FLOWS OR ABNORMAL EARNINGS. As discussed in Chap-
ters 11 and 12, we can also value a company using the discounted abnormal earnings and
discounted free cash ¬‚ow methods. These require us to ¬rst forecast the abnormal earn-
ings or free cash ¬‚ows for the ¬rm and then discount them at the cost of capital.
Step One: Forecast Abnormal Earnings/Free Cash Flows. A pro forma model of ex-
pected future income and cash ¬‚ows for the ¬rm provides the basis for forecasting
abnormal earnings/free cash ¬‚ows. As a starting point, the model should be con-
structed under the assumption that the target remains an independent ¬rm. The model
should re¬‚ect our best estimates of future sales growth, cost structures, working
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15-9 Part 3 Business Analysis and Valuation Applications




capital needs, investment and research and development needs, and cash require-
ments for known debt retirements, developed from ¬nancial analysis of the target.
The abnormal earnings method requires that we forecast abnormal earnings or net
operating pro¬t after tax (NOPAT) for as long as the ¬rm expects new investment
projects to earn more than their cost of capital. Under the free cash ¬‚ow approach,
the pro forma model will forecast free cash ¬‚ows to either the ¬rm or to equity, typ-
ically for a period of ¬ve to ten years. Once we have a model of the abnormal earnings
or free cash ¬‚ows, we can incorporate any improvements in earnings/free cash ¬‚ows
that we expect to result from the acquisition. These will include the cost savings, cash
received from asset sales, bene¬ts from eliminating overinvestment, improved work-
ing capital management, and paying out excess cash to stockholders.
Step Two: Compute the Discount Rate. If we are valuing the target™s postacquisition
abnormal NOPAT or cash ¬‚ows to the ¬rm, the appropriate discount rate is the weighted
average cost of capital for the target, using its expected postacquisition capital struc-
ture. Alternatively, if the target equity cash ¬‚ows are being valued directly or if we
are valuing abnormal earnings, the appropriate discount rate is the target™s postacqui-
sition cost of equity rather than its weighted average cost of capital (WACC). Two
common mistakes are to use the acquirer™s cost of capital or the target™s preacquisi-
tion cost of capital to value the postmerger abnormal earnings/cash ¬‚ows from the
target.
The computation of the target™s postacquisition cost of capital can be complicated
if the acquirer plans to make a change to the target™s capital structure after the acqui-
sition, since the target™s costs of debt and equity will change. However, the net effect
of these changes on the weighted average cost of capital is likely to be quite small
unless the revision in leverage has a signi¬cant effect on the target™s interest tax
shields or its likelihood of ¬nancial distress.
The following table summarizes how the discounted abnormal earnings/cash ¬‚ow
methods can be used to value a target before an acquisition (assuming it will remain an
independent entity), and to estimate the value of a target ¬rm to a potential acquirer.

Summary of Discounted Abnormal Earnings/Cash Flow Valuation for Targets
.........................................................................................................................
Value of target without (a) Present value of abnormal earnings/free cash ¬‚ows to
an acquisition target equity assuming no acquisition, discounted at pre-
merger cost of equity; or
(b) Present value of abnormal NOPAT/free cash ¬‚ows to
target debt and equity assuming no acquisition, discounted
at premerger WACC, less value of debt; or
Value of target to (a) Present value of abnormal earnings/free cash ¬‚ows to
potential acquirer target equity, including bene¬ts from merger, discounted at
postmerger cost of equity; or
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(b) Present value of abnormal NOPAT/free cash ¬‚ows to tar-
get, including bene¬ts from merger, discounted at post-
merger WACC, less value of debt
.........................................................................................................................

Step Three: Analyze Sensitivity. Once we have estimated the expected value of a tar-
get, we will want to examine the sensitivity of our estimate to changes in the model
assumptions. For example, answering the following questions can help the analyst
assess the risks associated with an acquisition.
• What happens to the value of the target if it takes longer than expected for the ben-
efits of the acquisition to materialize?
• What happens to the value of the target if the acquisition prompts its primary com-
petitors to respond by also making an acquisition? Will such a response affect our
plans and estimates?


Key Analysis Questions
To analyze the pricing of an acquisition, the analyst is interested in assessing the
value of the acquisition bene¬ts to be generated by the acquirer relative to the price
paid to target stockholders. Analysts are therefore likely to be interested in an-
swers to the following questions:
• What is the premium that the acquirer paid for the target™s stock? What does
this premium imply for the acquirer in terms of future performance improve-
ments to justify the premium?
• What are the likely performance improvements that management expects to

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