C13 M&A Flashcards
Steps involved in an acquisition valuation
(1) establish a motive for the acquisition
(2) Choose a target
(3) Value the target wrt the acquisition motive
(4) Decide on mode of payment: cash or stock. If cash, arrange for financing - debt or equity
5 Motives for acquisitions
(1) undervaluation
(2) diversification, with the intent of stabilizing earnings and reducing risk
(3) Synergy refers to the potential additional value from combining two firms:
(a) Operating synergy from higher growth or lower costs
(b) Financial synergy from tax savings, increased debt capacity or cash slack
(4) Control: Poorly managed firms are taken over and restructured by new owners, who lay claim to the additional value
(5) Managerial self-interest and hubris are the primary, though unstated, reasons for many takeovers
Sources of synergy
Value of control
value of control = firm value with restructuring — firm value without restructuring
inversely proportional to the perceived quality of a target’s management and its capacity to max. firm value
value of control negligible for firms operating at or close to their optimal value
2 Managerial self-interest/motives to merge and their difference
(1) conflicts of interest: managers may prefer to run a larger company due to additional pay and prestige
(2) Overconfidence: according to Roll’s hubris hypothesis overconfident CEOs pursue mergers that have low chance of creating value as they believe their ability to manage is high enough for a success>br>Difference: Under conflicts of interest explanation, managers know they are destroying shareholder value, but gain a personal benefit. Under hubris hypothesis, managers believe they are creating shareholder value (cognitive bias)
Choose a target firm wrt to the acquisition motive
Value the target firm wrt acquisition motive
Essence of relative valuation
The value of an asset is compared to the values assessed by the market for similar or comparable assets
Steps involved in relative valuation
(1) identify comparable assets and obtain market values for them
(2) Convert market values into standardized values, creating price multiples
(3) Compare multiple for the analyzed asset with comparables’ multiples, controlling for any differences between the firms that might affect the multiple, to judge whether the analyzed asset is under- or overvalued
Overview on how to create multiples
Types of multiples
(1) CF-based value multiples: Firm valueMarket/Earnings, Firm valueMarket/EBITDA, Firm valueMarket/FCF
(2) CF-based price multiples: Price/Earnings, Price/EBITDA, Price/FCF
(3) Asset-based multiples: Firm valuemarket/Assetsbook value, Equitymarket value/Equitybook value
Price Earnings Ratio (PE-ratio)
PE = Market price per share / Earnings per share
Earnings per share EPS = (Net Income - Preferred Dividends) / Average Common Shares
back out PE-ratio via dividens: PE = Payout ratio x (1+g) / (r - g) with Payout ratio = Dividends per share (DPS) / Earnings per share (EPS)
PE-ratio for FCFE model: PE = (FCFE/Earnings) x (1+g) / (r- g)
PE ratio and Fundamentals
Propositions, other things held equal:
higher growth firms will have higher PE ratios
higher risk firms will have lower PE ratios
firms with lower reinvestment needs will have higher PE ratios
Which multiple to use?
Managers focus on specific variables depending on the industry (which variables capture the sector’s characteristics best?)
Limitations of multiples
(1) No clear guidance about how to adjust for differences in exp. future grwoth rates, risk, or different accounting policies
(2) Multiples only provide information regarding the relative value of a firm in a comparison set, thus one cannot determine if an entire industry is under- or overvalued
